Sunday, February 20, 2011

10 Commandments

10 Investing Thumb Rules

Back of the envelope calculations may not be accurate to the last decimal but they give you a fair idea of what you are looking for. Here are some immutable financial rules that can help you with quick estimates. Use them to get a grip on your finances and make informed investments decisions.

** These rules provide only a rough idea. The actual amount after compounding may vary.

Rule of 72:
This tells you in how much time will your money double. Divide 72 by the interest rate you are compounding your money with and you will arrive at the number of years it will take to double in value

Rule of 114:
Use this to estimate how long will it take to triple your money. It works the same way as the rule of 72. Divide 114 by the interest rate to know in how many years will Rs 10,000 become Rs 30,000.

Rule of 144:
Similarly, this tells you in how much time will your investment quadruple in value. For instance, if the interest rate is 12%, Rs 10,000 becomes Rs 40,000 in 12 years.

Rule of 70:
This is a useful rule for predicting your future buying power. Divide 70 by the current inflation rate to know how fast will the value of your investment get reduced to half its present value. This is especially useful for retirement planning, as it affects the way you set up your monthly withdrawals. However, do remember that the inflation rate varies from time to time.

The 10,5,3, Rule:
This is a neat little rule that states that you can expect returns of 10% from equities, 5% from bonds and 3% on liquid cash and cash-like accounts.

The Emergency Rule:
Put away at least 3-6 months worth of expenses in a liquid savings account to ensure it is available at short notice
4% withdrawal Rule:
How much should I withdraw during retirement? We often use the 4% rule to protect the principle and determine how much one can take from the retirement savings. If every month you withdraw Rs 50,000 you need a corpus of Rs 1 crore (Assuming that the corpus earns 9% and the inflation rate is 6%) to sustain monthly withdrawals for the next 25 years.

100 minus your age Rule:
This rule is used for asset allocation. Subtract your age from 100 to find how much of your portfolio should be allocated to equities.

Pay yourself first Rule:
Right from your first salary, put away a little for your retirement. Experts say 10% of your income should go into this. It is important to increase the amount as your income rises over the years. In every month you invest Rs 5,000 in a plan that grows 8.5% annually and increase your investment by 10% every year then after 30 years you will have Rs 2.5 crore.

Are you Wealthy ?
Do you consider yourself wealthy? A rule-of-thumb formula used by Thomas J Stanley & William D Danko  in The Millionaire Next Door, a book that studies selfmade American millionaires, can help determine if you are.

(Age x Pre-tax income) / 10 = Net worth

The logic behind the formula is that the older you are and the more money you make, the more net worth you should have. Dividing by 10 is the rule-of-thumb that fits American conditions. So, if you are a 35 year old living in the US with an annual income of $6,00,000 a year, your net worth should be $2.1 million [(35 x 6,00,000) / 10 = 21,00,000] for you to be considered wealthy. If you are 20 years old and you make $3,00,000 a year, you would be wealthy if your net worth was greater that $6,00,000.

Indian Context: Indian financial experts argue that a divisor that's closer to 20 would be more realistic in the Indian economy. According to them you should use a sliding scale linked to age. At age 40, someone earning Rs 7,50,000 a year should have a net worth of Rs15,00,000. For a 20 year old, the divisor should be 25. Hence a 20-year-old earning of Rs 3,00,000 a year should have net worth of Rs 2,40,000.

Saturday, February 12, 2011

Reverse Mortgage

In old age, let your home earn for you

Reverse mortgage allows you to cash in on one of your biggest assets -- house. So, if you need funds during retirement, pledge your property to a bank and you can secure periodic payments throughout your life.

Under this scheme, the bank assesses the value of the mortgage-free house and fixes a percentage of its current value based on parameters such as the likely lifespan of the senior citizen and his spouse. Typically the loan amount is 60-70% of the market value of the property. The applicants have the options of taking the loan principal as a lump sum at one go or as fixed monthly installments. After the death of the person concerned, the surviving spouse can continue to occupy the property till his/her demise while getting the same benefits.

From time to time, the value of the property is reassessed by the bank. If the valuation has increased, the borrowers are given the option of increasing the quantum of the loan. If they have opted for the monthly payment scheme, this amount is increased appropriately.

The principal and interest charges accrue in the bank while the applicants spend their lives in the home, or till they decide to sell the home, whichever is earlier. If the sale proceeds are lower than the accrued principal and interest amount, the bank takes the loss. This could happen if the real estate market has not moved up in the manner the bank has estimated.

The rate of interest charged varies from bank to bank, but current rate ranges between9.5% and 11.5%. The borrower also has to bear some charges, such as those related to processing, valuation and legal proceedings, for availing of the loan. Despite the charges, the product has evolved and become more customer-friendly over time. The new scheme that was launched in 2010 is much more refined than the one introduced in 2007. Now, the insurance companies has also come into the picture and are offering better returns to the borrower.

The new reverse mortgage loan-enabled annuity (RMLeA) scheme has lots of advantages compared with the earlier product, which was marred by limitations such as low payments and a cap of 20 years.Under the new scheme, the borrower is entitled to a higher loan based on the higher percentage assigned to the value of the property. Also, the principal amount of loan remains intact and is available for repayment to the bank on the demise of the borrower. So the borrower's heirs only have the liability of paying the interest accrual.

Still the concept has not taken off in India in a big way unlike in western countries., where the product is popular. Indian are sentimentally attached to their homes. Here, a parent would prefer to pass on his house to his children, unlike in the West, where a child would rather start living on his won before he turns 18.

This concept is primarily for senior citizens. Unless someone explains it lucidly to them, they are unlikely to understand it. Often, the children don't explain or simplify the concept because they fear that they may be adversely affected if the house is repossessed by the bank after the death of their parents.

Saturday, February 5, 2011

Inflation Indexation

Use high inflation to bring down your Capital Gain tax

If petrol at Rs 60 a litre and onions a Rs 45 a kg are breaking your back, here's some cold comfort. The high prices could actually help bring down the tax on your long-term capital gains. The taxman understands that inflation is not only burning a hole in your wallet but also destroying the value of your investments over time. So he allows taxpayers to adjust for inflation by opting for indexation in case of long-term capital gains.

Inflation indexation takes into account the rise in consumer prices during the time the investor held an asset and adjusts his buying price accordingly. This lowers the effective profit from the sale of the asset and, therefore, the tax liability.

The key to indexation is the cost inflation index number announced by the government for each financial year. It is used to compute the indexed cost of an asset.

If you sell an asset-property, gold funds and debt-oriented funds --  at a profit, your gains are taxable. If they they are short-term capital gains, they are clubbed with your income for the year and taxed at normal rates. But if the holding period is longer, the gains are treated as long-term capital gains and taxed at a lower rate. The investor has the choice to pay a flat 10% tax on the capital gain or 20% after indexation. 

The taxman has different minimum holding periods for each asset. For debt funds (including fixed maturity plans), debt-oriented hybrid funds (including monthly income plans) and gold exchange-traded funds, this is one year. But for real estate and bullion, the minimum holding period is three years.

Investors in debt funds (especially FMPs) can use the indexation benefit to the hilt. If you had invested in a debt fund at the fag end of a financial year (say, in March 2008) and redeem the investment 13 months later in April 2011, you will be able to avail of indexation benefit of four financial years. In times of high inflation, this can reduce the tax liability to zero.

However, if you exit in February 2011, you will get the indexation benefit of only three years. As the above calculation shows, this may not result in a lower tax liability compared with that in the flat 10% option. so, your debt mutual funds or other assets that are liable for capital gains tax.

High prices could help you lower your tax liability if you opt for cost inflation indexation in case of long-term capital gains. Go through this calculation to find out if you should avail of this option.

Friday, February 4, 2011

Resell Property

Resell Property in 3 years... and lose half of your gains

The profit made from the sale of a house is never a simple calculation involving the subtraction of purchase price from the sale price.A number of income-tax caveats kick in. If you buy an apartment for Rs 50 lakh and sell it two years later for Rs 1 crore, your profit from sale will not be Rs 50 lakh. It will be much lesser.

Here is how the maths works:
If you sell within three years of buying: The first thing is to take into account is tax liability. If you sell a flat within 36 months of buying it, the profit is added to your income for that year, and taxed accordingly. If you fall in the highest income tax bracket, the tax rate will be 30.9%, which comes to Rs 15.45 lakh.

If you have taken a home loan: You will also have to take into account what you actually paid for the property in the first place. For instance, if you taken a home loan of Rs 40 lakh for buying the apartment you would have been paying an interest of 9.5% for the past 24 months. Your equated monthly installments (EMI) would work out to Rs 37,285.

Now under Section 80C of the Income Tax Act, the principal of the home loan can be claimed as a tax deduction. But if the property is sold within five years of buying, the tax deductions are reversed.

During the early years of a loan tenure, a major part of the repayment is tagged under "interest repayment". In your case, of the nearly Rs 9 lakh repaid over two years, only Rs 1.78 lakh is the principal repayment. The principal component will be added to your income for the current year and taxed at 30.9%. This means another Rs 55,000 skimmed for your profit.

Also, for two years you paid interest of Rs 7.17 lakh on the home loan. This will be deducted from your capital gain, which comes down to Rs 26.83 lakh (Rs 34 lakh - Rs 7.17 lakh).

Of your remaining home loan principal, Rs 38.22 lakh (Rs 40 lakh - Rs 1.78 lakh repaid as principal), the bank will levy a prepayment charge of 2.25%, which works out to around Rs 86,000.

After these deductions, the actual profit on the sale is only Rs 25.97 lakh, nearly half of what you had dreamt of. Most investors look at short-term real estate investments the same way and get carried away by stories of friends or colleagues who made lakhs within a year. However, before you are inspired to do the same, do your calculations, or better still, stick to your investment for the long term.

Being a Consultant

Pros and Cons of being a Consultant

They are not on the rolls of a company. They are not entitled to benefits extended to the regular staff. They also don't have the job security that a regular employee enjoys. Why then are consultants such a happy lot?
One reason why an increasing number of people are preferring to work as consultants is that the compensation structure promises the best of both worlds -- a high takehome income with a low income-tax liability. They are attracted by the benefits that consultancy holds out in terms of a lump-sum payment without any deductions and the freedom to deduct everyday expenditure like conveyance and utility bills from the taxable income.

In a consultancy, the individual bills the company for services rendered and gets paid a lump-sum amount for those services. He is not on the rolls of the company and is not eligible for any retirement benefits; there are no deductions like provident fund or pension contributions. There is only a 10.3% tax deduction at source.

The real benefit of being a consultant kicks in with the deductible expenses. The taxman treats a consultant's work as a business and extends to him the same benefits. If a consultant buys a computer worth Rs 50,000 for his professional work, his taxable income gets reduced by Rs 30,000 because he gets 60% depreciation on computers. A new car worth Rs 6,00,000 will reduce his taxable income by Rs 1,20,000 (20% of the price) in the first year, Rs 96,000 in the second year and almost Rs 75,000 in the third year. Buy a new phone worth Rs 20,000 and your taxable income goes further down. The furniture uses for office work, electricity bills, phone bills, driver's salary -- anything and everything that an individual spends on while going about his work are permissible expenses.

But hang on...there are some drawbacks too. A consultant does not get tax exemption for house rent, which is an important head of expenditure and can account for almost 20-25% of a person's salary. There are also no tax-free perks such as medical allowance and leave travel assistance.

Also, while the lack of PF contribution may fatten the take-home income, in the long run this might not be good. The PF is a convenient way of creating a retirement corpus. The money trickling into your account every month and the interest it earns every year accumulates into a sizeable nest egg. If he is not a disciplined investor, a consultant could face trouble after retirement.

The problems don't end here. A consultant has to maintain proper record of all work-related expenses incurred for up to eight years after filing the returns. It's a tedious process and mistakes could result in a notice form the taxman. Besides, those with an annual income of Rs 10,00,000 or more are required to get their expenses duly audited by a chartered accountant. Also, there is the additional botheration of service tax that has to be charged on every bill. So, assess the benefits and the problems carefully before you opt for this arrangement. You might be trading of less taxes with more hassles.

Wednesday, February 2, 2011

Know About Your SIP

SIP : Systematic Investment Plan

Five things you ought to know about your SIP

1. Keep sufficient balance in your bank
To start an SIP in a mutual fund, you need to give an ECS mandate or post-dated cheques to the fund house. But that's not the end of it. You need to make sure you have sufficient  funds in your bank account on the date of investment. Funds houses are usually quite lenient in these maters and will overlook one or two instances of an SIP cheque bouncing. But if it happens three times in a row, your SIP will be canceled for good. To restart it, you will have to do the paperwork all over again.

2.Useful of certain asset classes
You can invest through SIPs in practically all asset classes-- equities, debt, gold and even real estate. After all, your home loan EMI is an SIP in real estate. But SIPs work best in volatile asset such as equities. That way you are able to average out your purchase price over the long term. You don't really need to take the SIP route when investing in the debt market where the fluctuations are minimal. Also, one can consider investing systematically in gold, which is another asset class with some volatility and is a good hedge against inflation.

3. Each SIP is an individual investment
Like each EMI of a loan, each installment of your SIP is a separate investment and treated individually while calculating tax and exit loads. If you started an SIP in a equity fund two years ago and withdraw the entire amount today, the SIPs that were made more than 12 months ago will not attract any tax. However the profits from the past 11 SIPs will be liable to 15% short-term capital gains tax because they have not yet completed a full year circle. So, even though you might have started the SIP sever months ago, each installment must complete a year to escape tax net. Also, these 11 installments would also be slapped with an exit load because they are being withdrawn before a year. This also holds true for ELSS funds, wherein each installment has a lock-in period of three years. So after three years of starting an SIP in an ELSS fund, you can withdraw units of only the first SIP. The next month, units of the second SIP become free from the lock-in and so on.

4. Monthly option is best
In the past few years, SIPs have evolved significantly. Apart from monthly and quarterly options, you now have the option to enter the market at fortnightly, weekly even daily intervals. However, a monthly option still works best because of the operational ease it provides. While daily and weekly SIPs even out the fluctuations well, they add to an investor's paper work. Also, out cash flows are monthly and we plan most things on a monthly basis, so it's easier to keep money aside at that interval. The quarterly mode takes too long. By the time the trigger date comes in you might have used all amount.

5. What's the right amount
Some mutual funds allow investors to put in as little as Rs.50 a month through SIPs. That may appear tempting but won't help in wealth creation. Even if your fund churns out good returns and you remain invested for the long term, the small size of the SIP means you won't accumulate a significant amount. Sure, the amount of investment is defined by the investible surplus that an individual has. But don't opt for a small SIP just because it is being offered by a mutual fund. Assess the size of your financial goal and then save accordingly.

Gratuity Benefits

What is Gratuity ?
It is a lump-sum amount paid to an employee on exit or retirement. Companies use gratuity as a retention tool.

Who is Eligible ?
You get gratuity if you have completed five years in a company. But there is a cap of 10 lakh INR.

Are you ruing your decision not to change jobs while your peers jumped more than two or three times to land fatter salaries? Don't worry, because patience is not only a virtue but can also be very rewarding in financial terms. If you have completed at least five years of service, you are eligible for a fat lump-sum payment in the form of gratuity when yo are finally bidding farewell to a company. Your former colleagues, who changed every two or three years for lucrative new offers, will not be eligible for the same benefit.

Gratuity is one of the oldest employee-retention tool in the basket of HR managers. The objective was to make it lucrative for an employee to stay in the company in the long term and reap benefits. However, the gratuity has lost flavor over the years because job-hopping has become a norm.

Besides, patience is in short supply in this era of instant gratification. Young stars today are more concerned with cash in hand than what comes to them after 10-20 years. They do not think of long-term benefits and give no significance to benefits such as gratuity.

This can be a costly judgement error. Even with a small hike in your basic salary, your gratuity corpus can assume gigantic proportions over the long term. If someone starts his career at a basic salary of Rs.30,000 and get a nominal 10% increase every year, his gratuity at the end of 20 years will be Rs 14.1 lakh. However, the Payment of Gratuity Act, 1972, places a cap of Rs 10 lakh on the amount that a company has to pay as gratuity, although a company is free to give more if it wants to.

What's more, the tax exemption limit for gratuity has now been raised to Rs.10 lakh, which makes this long-term benefit even more attractive. Governed by the Payment of Gratuity Act, 1972, gratuity is a defined benefit plan. It is mandatory for companies with more than 10 employees on their payrolls to give gratuity to an employee on resignation, retirement and termination of service. However, an employee is eligible for this benefit only on completion of five years of continuous service with the company. Say, you leave after working for three years and rejoin after sometime and work for another two years, you are not entitled to this benefit.

But there are exceptions to this rule. The condition of minimum five years of service is relaxed in the case of death or permanent disablement of the employee.

How Gratuity is calculated?
It is calculated as 15 days' salary for each completed year of service. This salary includes your last drawn basic salary and dearness allowance(if any) but excludes all other allowances. For instance, if you have completed seven years of service and the last drawn monthly salary is Rs.45,000, you are entitled to a gratuity of Rs1.8 lakh (tax free). The gratuity rules are lenient when it comes to calculating the completed years of service. If one has put in more than six months during a year, it shall be treated as one complete year.

How Gratuity is taxed
Tax exemption to gratuity is the least of the following:
  1. Actual amount received. 
  2. 15 days' salary for each year of service
  3. Rs 10 lakh
No tax for government employees Gratuity rules are skewed in favour of government employees. For them, gratuity is fully exempt from income tax. For private sector employees, gratuity is exempt up to Rs 10 lakh. This limit has recently been raised from Rs 3.5 lakh earlier to make gratuity more attractive.

Tax free limit This Rs 10 lakh is the combined limit for the gratuity amount received by an individual over a lifetime. If you have received Rs 3.5 lakh as gratuity from a previous employer and get another Rs 8 lakh from the next employer, only Rs 6.5 lakh of the second payment will be tax-free. The balance Rs 1.5 lakh will be taxed as income.

Gratuity on death In case gratuity is paid on the death of an employee, the amount received by a nominee is tax-free subject to maximum exemption of Rs 10 lakh.

Excess payment If a company pays more that the gratuity amount as per the calculation given in the Gratuity Act, 1972, the excess amount is taxed as income at the applicable rate. If the gratuity adds up to Rs 8 lakh but the company pays the employee Rs 10 lakh, the excess Rs 2 lakh will be taxed even though it is within the tax free limit.

Earn from Credit Card

Credit cards means different things to different people. To some, it is a easy way to spend. Just swipe the card and you can buy anything, anytime, anywhere. To others, it is convenience. You no longer have to carry cash. But the 28 sq cm of plastic in your wallet is also the key to a treasure trove. If you are smart user, you can use it to unlock the myriad benefits that come with a credit card. Of course, you need to watch out for the pitfalls that include high interest rates on rollovers, hidden fees and the dangers of falling into a debt trap. But if you are a disciplined borrower, a credit card can actually be a source of free money.

Interest rates are on the rise and borrowing is costlier. But your credit card can help you get an interest-free loan for up to 50 days. Credit cards have a one-month billing cycle and customers usually get 20 days to pay bill. If you pay the entire bill by the due date, no interest is charges on the credit. So, if you time your purchases correctly and buy at the beginning of the cycle, the charges will appear only in the next month's bill and you could get up to 50 days of interest-free credit, or free money.

This strategy works best if you have two or three credit cards, each with a different billing cycle. You can get your billing cycle changed to be able to optimize on this interest-free credit.

Do keep in mind that this is possible only if you settle your credit card bills in full by the due date. If you roll over the balance by paying the minimum 5% of the bill, you are charged 2-3% a month on the unpaid amount. Plus, you don't get interest-free credit on new purchases if the billing period starts with a balance.

The more the number of cards, the more careful you have to be about billing cycles and payment dates. If you slip even once during a year, there's a hefty late payment penalty as well as the interest charges on the balance which could wipe out the gains of several months of careful spending.

Dropping a cheque in the drop box on or before the due date is not enough. Credit card companies consider a payment only when the cheque gets credited. So drop it at least 2-3 days before the due date if you don't want to be slapped with late fees and other charges.

7 Faces of Profit

Its the time of the year when quarterly reports flood mailboxes and dailies, and the words 'earnings' and 'profit' jump out from all over. But which profit should you consider to evaluate a company ? What is the utility of profitability measures ? Here's a guide to understanding profits.

1. Gross Profit
It is the amount earned from sale of products after deducting production costs.
What it does:
Signals efficiency with which a company is making money. Indicates how much mark-up a company can generate on its sales. A company with rising gross profit means it can command premium prices, cost efficiency, and makes the company highly competitive.
Black spots:
Works as a primary indicator. G.P. is similar to an incomplete story. To know more about the company, you have to read other signs.

2. Ebitda
It means earnings(or profit) before interest, taxes, depreciation and amortization. Calculated by subtracting operating, general, administrative and marketing expenses from gross profit.
What it does:
Measures profitability. Say, you are having trouble deciding between companies, it is the best tool to compare them because it weeds out the effects of financing and accounting decisions.
Black spots:
It is not a good measure of cash flows. Companies may use it to dress up earnings.

3. Ebit
It is the earnings before interest and taxes. Calculated by deducting depreciation and amortization charges from Ebitda.
What it does:
Measures a company's earning capacity. Examines performance of companies by negating the effects of financing and taxes. Useful for shareholders and creditors.
Black spots:
Ignores unavoidable cash outflows due to interest and taxes.

4. EBT
It is the earnings (or profit) before taxes and is calculated by deducting interest expenses from Ebit.
What it does:
Compares companies in different tax jurisdictions. Useful for comparing companies within a sector. Shows how well a company is using its borrowings to enhance its return on equity.
Black spots:
Again, doesn't give a wholesome picture. Discounting the tax effect is unwise.

5. EAT
This is the Net Profit. Earnings after tax, or net profit, is the most common way to calculate a company's profit. EAT is the company's profit after deducting manufacturing and operating expenses, depreciation, interest and tax.
What is does:
Tells the story of a company's performance over a period. Handy tool for equity shareholders as it is the money left after a company makes all payments. EAT helps shareholders analyse the earnings of a company on a per-share basis. Equity dividends are also based on EAT.

6. EPS
Earnings per share is calculated by dividing net profit by the total number of shares.
What is does:
Considered the single-most important measure of a share's price. Shows how much a company is earning on every share. For example, if a company makes a post-tax profit of 12 lakh INR and there are 2 lakh shares in issue, the EPS would be 6 INR.
Black spots:
Ignores capital. Two companies can have the same EPS, but the second company may have used lesser capital employed. Other things being equal, the second is the better company as it is more efficient.

7. P/E Ratio
P/E = Current share price of a company divided by its earnings per share.Though not strictly a measure of profit, it is a favourite tool of analysts to measure a company's value. It tells if a share is overvalued or undervalued.
What it does:
Shows how much an investor is willing to pay for every rupee of a company's earnings. Analyst use a forward P/E ratio to fix target prices of companies. Generally, a high P/E means investors expect higher earnings growth in the future.

Black spots:
The PE, at best, a lagging indicator, which takes into account only the past earnings, not the future growth. As such, a low PE may give the impression that the stock is undervalued, but if the company's earnings are not growing, its value is also not likely to rise. Similarly, a high PE could make a stock's valuation seem stretched, but what if the company's earnings are likely to keep growing rapidly? In such cases, using the PE ratio would not be a good idea. 

8. PEG
Price to Earning Growth metric. It is essentially an enhanced version of the PE ratio, which combines value with growth. the PEG ratio is calculated by dividing the stock's PE ratio by its expected 12-month earnings growth rate. (PEG ratio = PE / earnings per share growth). 
What it does:
The premise for using this ratio is rooted in the understanding that the growth rate of a stock that is valued correctly would be almost equal to its PE ratio. In other words, The PEG ratio of a fairly valued stock would ideally be equal to one. When the PEG is equal to one, it means that the market has correctly factored in the expected earnings growth. A PEG ratio of less than one would mean that the market has not adequately priced in higher growth expectations and that the stock is, therefore, undervalued. A PEG ratio higher than one implies that the market is paying much more for the stock than is justified by its earnings growth. So, the lower the PEG of a stock, the better it is.
Black spots:
Its not foolproof indicator of value. Since it is a forward looking measure, one has to rely on analyst's projection of future earnings, which may not always be accurate.