by Anand Saxena
The latte is just a metaphor and we all have our own lattes in life—a packet of cigarettes, bottled water, weekend movie with pizza, the list is virtually endless. What is needed is to pause and reflect upon your own latte, which can be eliminated or reduced in order to have surplus amount available for investing or looking after your needs (augment your 50 percent bucket.) Let’s take the example of HoneyCool who is very passionate about watching a movie, followed by a glass of beer and pizza every weekend. Of course, he can afford it and of course, he has catered for this expenditure out of his wants bucket (30 percent bucket.) This innocent weekly fun outing, costs him around ₹1,000 (movie ticket with coke and popcorn, glass of beer with some snacks and a double cheese chicken tikka pizza et al.) So, over a month around ₹4000-5000 are spent in this innocuous activity.
Taken to an extreme if we assume that HoneyCool cuts down this activity completely and invests the money in a financial instrument which gives him a return of 12 percent over time, how much has he saved over next decade? A cool eleven lakhs and twenty thousand rupees. How about over the entire investing lifetime of 35 years? It grows to a humongous amount of ₹2.75 crores. All right, HoneyCool is entitled to his share of fun and he must have that but suppose he decides to have only two movie or pizza weekends instead of four in a month and spends the other two weekends watching TV, reading books, visiting friends or parents—possible? Even this little ‘latte sacrifice’ will make him richer by nearly ₹1.4 crores, enough to buy a Pizza Hut outlet I guess. The idea I am trying to get at is that if one can cut down on small little expenditures without compromising on the quality of life, the financial dividends could be out of proportion.
Another connected issue is of ‘impulse purchase’ which we all experience from time to time. We are just looking around or window shopping in a mall and lo and behold! find ourselves with a t-shirt, skirt and nail paint in our shopping cart. Of course, we never meant to purchase it, to begin with, but the ‘70 percent off’ offer was too good to resist. One invariably gets stuck with things we could have planned to buy later, if at all. How to avoid it? Be very clear about your ‘want budget’ for the month, maybe further divide it into a weekly budget and carry only that much in your wallet as cash. Absolutely no credit or debit card for ‘want’ purchases. When the weekly wants money runs out in the wallet, well, wait till the next weekend. In extreme cases avoid going to such tempting places altogether unless you plan to buy something.
Even if something appears too tempting and is almost a need, should you just buy it? It is better to give each ‘significant purchase’ some time before you commit yourself to buying it. A significant purchase could be something which costs more than one week’s take-home pay—fair one I guess. So in case of Anshreya or HoneyCool, any purchase in excess of ₹12,500 (they earn ₹50,000 per month) will fall into this category. And how long should one mull over before purchasing? At least the amount of time one would take to earn that amount. So our protagonists should wait it out for one full week before buying something which costs upwards of ₹12,500. If it is really a need, do buy after one week, but invariably, one will find that the thing no longer appeals to you or you can think of better utilisation of that amount.
Key Takeaways
Introspect to find out your ‘latte factor’ and consider eliminating or reducing this expenditure.
Device innovative means to avoid impulse purchases.
Give yourself sufficient time before making a significant purchase.
MUSING 10: CREDIT CARDS AND CREDIT SCORES
All the authors of personal finance books that I read, and I did read nearly fifty of them, are dead against the use of credit cards. One of them, Dave Ramsey, in his book ‘The Total Money Makeover’ goes to the extent of urging the readers to cut their credit cards into two—yes you read that right, just cut the credit cards off. And this advice is not without some good reasons, a few of which I would elaborate and leave you to make your own judgement.
Like investing is using today’s earnings for tomorrow’s spending, credit or borrowing is using tomorrow’s earnings for today’s spending, fundamentally a bad concept. The biggest problem with credit card usage is that it engenders a habit of overspending beyond one’s needs or wants budget. One gets tempted with the interest-free payment period of 50 odd days and may get into a vicious cycle of mounting credit card debt.
The second problem is seemingly benign rates of interests—only 1.5-3 percent (per month is in fine print) which can burgeon into a humongous debt within no time. We will take an example: In general, credit card companies charge interest at a rate of 1.5 percent per month (18 percent per annum, pretty hefty indeed). Suppose HoneyCool has a balance of ₹2,000 on his credit card for which the minimum payment is ₹40 (generally 2 percent of balance.) Because he has ended up spending more than his budget for the month, he decides to pay only the minimum balance of ₹40. This amount of ₹40 does not get deducted entirely from the principal amount of ₹2,000, instead the credit card company charges him a ‘finance charge’ of 1.5 percent of the total outstanding balance i.e. ₹30 (1.5 percent of ₹2000.) Now this amount of ₹30 is first deducted from his minimum payment of ₹40, so he ends up contributing just ₹10 (₹40-30) towards paying off his principal which now remains ₹1,990. This spiral is so vicious that HoneyCool will take 30 years to be rid of this ‘small’ debt of ₹2,000 if he continues to pay only the minimum payment, during which an interest amount of nearly ₹5,000 will be paid to the credit card company.
Coupled with this is the issue of ‘opportunity cost’ that HoneyCool has to bear because he had ₹2,000 less to invest over and above what he paid for interest payments. Over a period of 30 years of investment— ₹2,000 invested at the rate of return of 12 percent would have given a cool sum of ₹60,000 to HoneyCool.
Even one missed payment of credit card balance or large outstanding amount adversely impacts your credit scores resulting in difficulty in getting loans or getting them at competitive rates. I will not go to the extreme of proscribing the use of credit card totally—may be having one credit card which is used responsibly (SI balance maintained) and paying off the balance in full in every billing cycle is not a bad idea. However, there is a better way to manage unexpected expenses which we have already discussed, by having a breathing fund, which automatically obviates the need of owning or using a credit card.
Credit Scores
One must know that every time we apply for a loan or a credit card, the agency concerned does an enquiry into our credit history which is denoted by a CIBIL (Credit Information Bureau India Limited) Transunion score, which is between 300 and 900. The higher the number, the better are your chances of getting a loan at more attractive rates. Generally, a score of more than 750 is considered good.
The credit score is a sum total of many factors which are as follows:
Your credit history is the most important of these factors, accounting for 30 percent of the total score. If you have been diligent about paying off your monthly dues and EMI, your score will be higher. Any default impacts the score very adversely. Any new credit you take including a new credit card lowers your credit scores.
This is followed by your credit types and duration which accounts for 25 percent of total score. So secured loans like home or car which are normally against collateral (guarantee) will give you a higher score than an unsecured loan like credit card and personal loan.
Credit utilisation also accounts for 25 percent of the score. It depends upon your credit limit against which you have taken the loan. A higher percentage of loan against overall credit limit is viewed negatively.
Miscellaneous factors account for 20 percent of the score which include your recent credit seeking behaviour like credit card applications etc.
One important point to take note of is that your credit score only shows how good a borrower you are and not your overall financial health. So, if you are managing your finances well following the tenets of the musings in t
his book because of which you have never taken a loan and yet succeeded in building your net worth to ₹50 lakhs, you will still have a low CIBIL score. If you go for a loan, you will be offered one at a higher rate of interest. Isn’t it ironic? You bet.
Key Takeaways
As you start earning there will be a flurry of offers from credit card companies enticing you with lucrative deals. It is advisable to avoid taking on a credit card burden.
One should instead build up a breathing fund to obviate using a credit card.
If at all you go for a loan, go for secured ones like home and car loans and not unsecured ones like personal loan.
Be punctual in paying off your EMI or monthly due on credit card in full, every month or else your credit score may be adversely affected.
MUSING 11: DEBT MANAGEMENT
“The rich rule over the poor and the borrower is the slave of the lender17.”
We have tackled the issue of credit card debt separately and before tackling any other kind of loans and debts because it probably is the single most pernicious habit which encourages a person to live beyond his means. There are plethora of loans and debts out there which are available easily, perhaps too easily, and invariably, all are avoidable. Before we tackle these debts, just take a moment to reflect upon the musing on assets and liabilities and try and differentiate between good and bad debts. Any debt which helps you build up an asset would construe a good debt, thus putting all other debts squarely in the category of bad debts.
A mortgage or loan taken to buy a house will fall under the category of a good debt with a few caveats. Obviously, a home loan helps one to own a financial asset which otherwise may prove to be beyond one’s means and hence qualifies as a good debt. But the sheer size of this debt and its long duration makes it incumbent upon us to pause and reflect before we commit. For this reason, there is a separate musing dedicated towards this issue.
An Education Loan taken to build up one’s qualification which in turn helps in earning better will also qualify as a good debt. The important point is to be sure that one gains adequate income accretion after acquiring the qualification which would help in paying off the loan. Parents need to be especially careful before taking an education loan for the child for she may be saddled with a financial millstone of loan EMI round her neck, once she starts earning. The ‘follow the herd’ mentality of going abroad and earning an undergraduate or postgraduate degree which does not result in commensurate earnings must be strictly avoided. There is a better way for your child to earn her qualification with dignity entirely funded by you as parent and shall be covered under the musing of ‘children’s education.’
A loan taken for the purpose of setting a business up (start-up) or expanding existing business would also qualify as a good debt. One has to be careful that one builds up assets with the loan and not liabilities and the amount of the loan should be within reach and not become a burden if the returns do not accrue immediately.
All the consumer loans including personal loans are bad because they invariably cater to buying liabilities (revisit the definition please) and engender the tendency to live beyond one’s means. It also results in the opportunity cost of the amount being paid for as EMI, not being invested to earn compound interest.
Let’s calculate the real cost of owning an iPhone X, which costs ₹1 lakh and for which HoneyCool has taken a consumer or personal loan of ₹90,000, at the rate of interest of 13 percent (normal existing rates) paying the remaining ₹10,000 from his pocket. The EMI for the phone, for a period of three years, works out to ₹3,032 and hence HoneyCool pays a total of ₹19,168 as interest over three years. Suppose he had invested this EMI amount of ₹3,032 along with ₹10,000 that he paid upfront for the phone for three years at the rate of return of 12 percent, he would have got a sum of ₹1,44,000 (₹1,30,000 + ₹14,000) enough to buy an iPhone X cash down with ₹44,000 available for his breathing fund. This amount of ₹3,032 would have come out of his want bucket (the 30 percent bucket.) The only sacrifice required would have been to control his ‘present bias’ (a fancy term for the tendency: I want it now.) But the advantage would have been to inculcate a habit of living within his means and a solid breathing fund. This approach to purchase something significant is also termed as the ‘sinking fund approach.’
Car loan is another interesting topic. A car at the end of the day is just a means of transportation and hence any decent used car maybe 1-2 years old would suffice for one’s needs. All the financial authors that I read are unanimous on the opinion that a new car should not be purchased until one can pay for it in hard cash which is generated out of one’s assets. In all other cases, without fail, one should buy a one or two-year-old used car and drive it for 7 to 10 years before repeating the process. Please read the book “The Millionaire Next Door” by Thomas J Stanley and William D Danko, which outlines the real lives of America’s millionaires (most of them buy 2 to 3-year-old used cars) to learn this point in action. Author Vicki Robin in her book “Your Money or Your Life” gives a very interesting simile: when you eye that swanky SUV costing ₹20 lakhs, remember, you are locking up more than three full years of your life in the car (assuming the take-home pay of ₹50,000 per month,) as that much time will be taken by you to pay the loan off.
Thumb Rules for Loans18
The EMI from all the loans put together should not be more than 50 percent of one’s net income. A further suggested breakdown, subject to the above caveat is for car loan not to exceed 15 percent, home loan 40 percent and personal loan (never take it please, it bleeds you) 10 percent.
An easy way to track the above is by tracking one’s loan to income ratio ((total EMI/Net monthly income)*100) whose limits should be as follows. 20-25 percent: comfortable, 25-40 percent: Caution, 40-50 percent: Stressed and more than 50 percent: Alarming. Try and follow these yardsticks. Remember, missing even one EMI is going to hurt your credit scores badly, so be very careful while taking on a new loan.
Remember to cover your loan with an insurance of equal amount and a matching term or a term plan which continues even after the loan is paid off. The loan tenure should be as short as you can afford subject to your EMI paying capacity. The longer the loan, the greater is the interest being paid. Also be alive to the possibility of paying off the loan earlier than the original term. Even a marginal extra payment will go a long way. Please see the example below for a loan amount of ₹50 lakhs with tenure of 25 years19:
• Paying one extra EMI per year— Loan finishes in 19 years 3 months.
• Hike EMI by 5 percent each year— Loan finishes in 13 years 3 months.
• Hike EMI by 10 percent each year— Loan finishes in 10 years 2 months.
The Debt Snowball20
Dave Ramsey is an American bestselling author and a radio host (a very powerful orator) who also runs the ‘Financial Peace University.’ He emphatically states “Personal finance is 80 percent behaviour and 20 percent head knowledge,” a dictum I fully believe in. Dave has outlined a simple and effective plan of ‘seven baby steps’ to get out of debt and rebuild one’s life if the debt burden has become unmanageable. If you follow the advice given in this book, you will possibly not be required to follow his ‘seven baby steps’ method. However, if you have laid hands on this book late in life and are debt-ridden, do follow these steps. I’ll outline the steps below and also provide a link for his video, which I consider a must watch.
https://www.youtube.com/watch?v=z48jmMh_Bwo
Baby Step 1: This is akin to building the ‘baby’ breathing fund we learnt about in the earlier musings. Dave recommends a $1000 (say ₹70,000) beginner emergency fund to take care of life’s emergencies. He has outlined the steps to get to this figure fastest, within a month.
Baby Step 2: This step is about paying off all debts using ‘debt snowball’ method except home mortgage. Essentially, Dave advises one to concentrate towards liquidation of the smallest debt first followed by the next bigger one and so on. The snowball eff
ect is achieved as the additional amount you are left with after paying your, say, first debt is added to clear off the second debt and so on. He recommends completing this step in 12 to 24 months during which one has to stop all other investments and savings.
Baby Step 3: This step is about putting three to six months of expenses into savings as a full breathing fund. This money is to be put into a separate account preferably a liquid fund or money market account (don’t get flustered by this jargon, we will reach there soon with our musings.)
Baby Step 4: This step is about building a retirement corpus by investing 15 percent of one’s household income into retirement plans, preferably in tax-deferred ones (meaning that you don’t pay tax while your money is growing). Dave mentions Roth IRA here which is specific to the U.S. but as you move along to the musing on ‘Saving for retirement’, similar Indian options will become clear to you.
Baby Step 5: In this step, one has to begin college funding for the children. Here again, the equivalent Indian options are given under the musing on ‘children’s education’.
Baby Step 6: This step talks about paying off the home loan early. Dave gives good reasoning against the tendency to keep the home loan going in order to gain tax advantage. This step, he reckons, can be completed in seven or eight years because Baby steps 4, 5 and 6, are to go on concurrently.
Baby Steps 7: This step is about sharing one’s wealth with the needy i.e. get into charity to share your wealth with the underprivileged of the society.
Key Takeaways
All loans except home, education and the loans taken to set up or expand one’s business (with caveats) are invariably bad and should be avoided.
All consumer goods should be bought through the ‘sinking fund’ approach.
Instead of taking a car loan, it is better to buy a one or two-year-old used car unless one is able to pay for it in cash generated over time from the assets acquired.