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Thursday Trivia ~ Are you Financially Free?

 

Rahul, Divya and Mahesh are childhood friends. Everyone likes to call them  – 3 Musketeers! Right from staying in Mumbai’s suburbs during their school and colleges days to now living in posh locality of South Mumbai, their journey is not less than anything inspirational. Those sleepless nights before exams, traveling in local trains, chai-samosa parties, etc. are some of the unforgettable memories that they relive whenever they meet.

Rahul rose through the ranks of corporate ladder after completing his professional education. Divya became a doctor, she is a visiting doctor to many hospitals in Mumbai. Mahesh established a business while he was in college and has now established into a global company.

As Rahul turns 40 today, he stands on the balcony of his penthouse with Divya and Mahesh next to him reliving those days when they were hustling through life.

‘Life has blessed us with so many fond memories. We used to study till 4 am and write exams the very next day. Not to forget the chaiwalah who used to come at 1 am in the morning and ask us about our preparations for tomorrow. Remember how Mahesh used to confidently say, that we will crack the papers wide open!’ remarked Rahul.

‘Oh yes and we would be worried about whether we will be able to write the paper tomorrow or not,’ laughed Divya.

‘And we did crack the papers every single time. Didn’t we?’ smiled Mahesh.

‘Most definitely we did.’ Divya winked.

‘Seriously, I had to climb the hard corporate ladder and work around my loans for my house and Mercedes while Mahesh has been able to buy three houses and 2 BMWs by now. He seems to have some magic wand.’ Rahul said.

‘I never buy anything on loan. We have a saying in our family, a person works for 12 hours while his interest on loan works for 24 hours. The only loan we take is for business expansion and new product offerings.’ Mahesh replied with ease.

‘WHAT!! You have never taken a personal loan. Then you’re surely missing out on great things of life buddy. See this phone of mine, it’s worth Rs. 1.25 lakhs. I couldn’t afford paying straight away so I got an easy EMI option on it. I just bought my first Audi too and have my bank’s relationship manager working on a house that we are planning to buy in next 6 months. It really improves my image as a doctor, you see.’ Divya anxiously replied as she couldn’t believe Mahesh never ever took a loan.

Mahesh sensed Divya’s anxiousness. He replied, ‘That’s wonderful Divya. I am glad to see you so happy. You are a wonderful doctor but very bad at managing your money.Since you were so busy studying those big books, you never got the time to understand the power of compounding.’

‘I agree with Mahesh. Understanding money and power of compounding is a must, Divya. It’s the 8th  wonder of the World.’ Rahul interrupted.

‘I don’t believe Mahesh at all. Even Rahul took a loan for your house and Mercedes. So what’s wrong with me taking one?’ Divya was getting a little irritated now while Mahesh maintained his composure.

‘Yes, Divya. But then look at what I had to go through. Most of my money was being spent on servicing the EMIs on loans. Though I don’t have any loan on my head right now, I also don’t have any money sitting in my bank right now that will help me retire. If my daughter gets hospitalized tomorrow, I will have to take loan from you and Mahesh to help me out. Next option is credit card.

Technically, I am still a slave to the system. I can’t escape my job. I am still working for money, I just disguise it saying that it’s my passion. But it’s far from truth and you know that.’ Rahul choked while speaking.

‘Divya, don’t get me wrong. But the loans that you are enjoying today are just financial burdens of tomorrow. You still aren’t able to take your personal time off from work. It’s creating a pressure for you when in reality. You want to start a charity for underprivileged since a long time but you aren’t able to because you don’t have time. You are chasing money while dreams are slipping away.’ Mahesh chose his words carefully this time as Divya went into deep personal enquiry.

Silence for 5 mins.

Finally Divya started talking. ‘You guys are right. I have achieved so much as a doctor but there is no freedom in my personal life. I still cannot take 1 week off from work and spend time with my children. Home loans, car loans and now a loan for phone too. There is no money sitting in bank account that can be used if some emergency in family comes up. Retirement is completely out of picture, at least you have even thought about it Rahul, for me it’s a distant reality.’

Rahul got up to get a juice for Divya. On coming back he asked, ‘Mahesh how the hell did you do it? I mean, how did you become financial independent with so much stress from business every single day?’

To which Mahesh replied, ‘I never really took a loan to fulfil any of my desires. Whatever money we made, we continuously invested back in our business all the time. Plus since last 10 years, we have been investing mutual funds as well.

When you own a business, you own a piece of growth. It starts small and slowly compounds over time. Remember the days when you bought your first car and I was still traveling by public transport. I had the option of taking a loan but didn’t want to burden myself. While Divya was enjoying Europe, I was enjoying Kerala. The idea was to let money work for me.

And it took off. In last 12 years, we saw immense growth in our business. Then even our holdings in mutual funds grew and suddenly we were having more money than we had ever imagined. My business makes enough money for me to not work for a few years. My investments have earned me financial retirement. I am happy with my phone which serves the purpose of emails, chats and calls. There is no financial pressure, what more could I have asked for in life?’

Divya was listening with great interest when Rahul interrupted.

Owning a piece of business is so important. I had ESOPs of my company but I sold it off for down payment of my home. Those shares are worth 5x more today. I realize now that I made such a big blunder.’ Rahul almost stopped drinking his juice.

‘That’s in past Mahesh. Now what shall we do?’ Divya looked highly concerned now.

‘Don’t worry. We will crack this paper of your financial life wide open too, just how we did during exams’ winked Mahesh.

‘That’s the spirit boys!’ yelled Rahul with excitement.

Mahesh said, ‘listen to me very carefully now, just don’t interrupt. First and foremost, repay every loan you have. Especially your loan for Audi, Divya. If you don’t need that car then don’t buy. You are not impressing anyone. Just putting too much financial stress on yourself. And for that second home you are buying with loan, cancel that too. Find a nice broker and sell that house. You don’t need an extra house right now too.’

Divya politiely asked, ‘My dearest Mahesh, how do I repay my loans and start investing? I will need someone to guide me through the process. I am not born with mastery in numbers, like you!’

Rahul laughed while Mahesh was gathering his voice.

Mahesh replied, ‘Yes Divya, as always you are right. You need a Financial Advisor to help you through this. Just the way you take care of your patient’s health, your advisor will take care of your financial health. An advisor will see to it that you don’t overspend your income, invest the balance and see to it that you don’t take up unnecessary loans. This will secure your retirement and you will be able to work without having to worry about money any single day.’

‘Wow Mahesh. Do you have anyone in mind?’ enquired Divya with great excitement.

‘We have a financial advisor who will help you out with the process.’ Rahul intervened.

‘What!! Both of you already have one and never told me about it!’ yelled Divya.

‘That’s because you never want to discuss about investments ever with us.’ Mahesh replied.

Rahul replied, ‘Yes. I invest some portion of my salary every month into mutual funds. Also have an emergency fund set up, if I am unable to work for 3-6 months. Since I paid my complete home loan last year, I will be able to gain complete financial independence in the next 5 years. My advisor keeps a very good track of it.’

Mahesh looked at Divya and said, ‘Sit with the financial advisor for a few hours and plan a life of complete financial freedom. Just don’t let your fear or greed get in the way. It’s okay to get rich slowly because ultimately you will get rich. Getting rich fast, never really happens!’

‘Wow. What a speech, can’t get enough of it!. But for now, we are hungry and need food. Right now, we wish to focus on independence from hunger!’ Rahul smiled and thanked Mahesh.

 

Today’s Thursday Trivia has taken its inspiration from the tweet of Mr. Steve Burns. 

The most satisfying personal finance achievements:

  • No credit card debt
  • No car payments
  • Home can be paid off
  • No debt
  • Emergency fund
  • Big retirement account
  • Big trading account
  • Cash flowing assets
  • No financial pressure
  • Financial independence from a job

 

– Jinay Savla

 

Thursday Trivia ~ What is Recapitalisation and How it impacts you!

What would you do if your child is unhealthy? You will take him / her to a doctor. Medicines will be prescribed. Yet, child continues to remain unhealthy. Now, there will be complete body scan. Upon reports when doctors realise medicines are not enough, they would prescribe surgery. Yes, surgery.

Similarly, banks in India have been unhealthy for quite some time now. So what can government do? In 2008, after Global Financial Crisis banks in USA were bailed out by taxpayers money. However, in India the crisis is not so severe. Hence, government has resorted to Bank Recapitalisation through a transparent financial engineering process.

Need for Recapitalisation

As per the banking norms, for every loan a bank makes it needs to have 10% of it as capital. So if a bank wants to lend Rs. 10,000 to someone, it needs to have a capital of Rs. 1,000 with it. Now, if the loan defaults by even Rs. 200 then it directly affects the capital requirement. Capital reduces (1,000-200) to Rs. 800 as a result of such a default. As a result, for Rs. 9,800 worth of lending, bank now only has a capital base of Rs. 800 which is 8.15% of the capital. Doesn’t fit the capital adequacy requirement of 10%.

At this point, either the bank can call in the existing loan which isn’t possible so they stop lending more. This stops credit take off from it’s very source – banks. Hence, the need for recapitalisation.

Structure of Bank Recapitalisation 

  • Bank Recapitalisation Bonds – Government will issue bonds worth of Rs. 1.35 lakh crores to Public Sector Banks. The banks in turn, will buy these bonds from government. The same money would be utilised by the government to buy shares of public sector banks.
  • Through budgetary allocation (taxpayers money), government will buy Rs. 18 thousand crore worth shares of Public Sector Banks.
  • Lastly, Public Sector Banks will then need to raise Rs. 58 thousand crores from market.

This adds upto a staggering Rs. 2.11 lakh crores. Indeed our public sectors banks are unhealthy.

Impacts on different stakeholders of Recapitalisation

Public Sector Banks

Banks which have already made appropriations for Non Performing Assets (NPA) will now be forced to recognise them as losses. Which in turn would result in erosion of capital. This erosion would be compensated by government by infusing capital by buying shares through bank recapitalisation process. Net effect, banks will be able to erase off their non performing loans while keeping their capital requirements intact. This would make banks healthier in process and would be able to make fresh loans.

Only caveat here is as banks will purchase these recapitalisation bonds, government will have to pay an interest on the same. This will add to fiscal deficit. Experts argue that interest amount of Rs. 10,800 crores a year considering 8% interest rate is won’t affect India’s fiscal health. However, every drop counts.

PSU Bank Shareholders

Shareholders of PSU banks will see a drop in book value of shares they hold.

How?

Let’s look at this example. Mr. A invested Rs. 200 in a PSU bank. Issued capital of the bank is Rs. 10,000. Hence safe to say that Mr. A holds 2% in the bank. Now, government infuses Rs. 30,000 to recapitalise the bank. As a result, Issued capital of the bank becomes Rs. 40,000. However, Mr A continues to hold Rs. 100 worth of shares in the bank. As a part of restructuring, Mr A will now hold 0.8% of the shares of bank. Hence, shares held by PSU Bank shareholders will get diluted.

However, it’s important to note that price of the shares have not been reduced. On the contrary, after the announcement of this scheme, PSU Banking sector index has seen a rise of 33% till date. Which means, shareholders need not worry on this issue.

Depositors

For depositors nothing changes. Apart from the fact that they can now place more confidence on solvency of the bank.

So if you had your fixed deposit in any public sector bank and were worried for a while. Then government will tell you to relax, the invisible hand is there to support you.

Taxpayers

Some of our investors raised an important question pertaining to bank recapitalisation. Central theme of their question was ‘Why should we ‘taxpayers’ bail out immoral and wilful defaulters?’ This definitely is a very important question in this context.

However, it’s important to note that in last year’s budget Finance Minister had made an allocation of Rs. 18 thousand crores for banks from the government for which the provision has already been made. Even with this announcement, no fresh allocation of taxpayers money is allocated. As a result, there is nothing to worry for taxpayers.

Investors

Bank recapitalisation will help to accelerating structural reforms in Indian economy. Infrastructure reforms such as roads, railways, power etc., transport sector will also get immense benefit on the back of proper roads being built plus Goods and Services Tax has already brought down gestation period of tucks at inter-state toll booths, manufacturing companies will be able to not only provide for consumption in India’s economy adding exports will help to put India firmly on global map.

By fixing the credit supply in the system, bank recapitalisation will prove to be a win-win for all stakeholders.

Can consolidation of PSU Banks happen?

The constitution of Alternative Mechanism is a step ahead in their direction. In August, Union Cabinet had decided to consolidate existing PSU banks under this mechanism to create stronger banks. Committee for Alternative Mechanism will be headed by Finance Minister Arun Jaitely.

One question that always strikes our heart is ‘How did situation become so bad in the first place?’ We were such a strong economy on the path to become a superpower but all fell apart.

What happened in the context of Public Sector Banks?

Flashback 2014, then Reserve Bank of India Governor Raghuram Rajan, brought to light the unhealthy state of banks. He pushed for an asset quality review. Till that time, most of us thought ‘all is well’ and then looking at bad assets amassed we were informed that ‘all is really not well’. The numbers  of ‘Non Performing Assets (NPA) ’ (loans given by bank which cannot be recovered) we saw were spectacularly high.

Due to this, banks were not only able to lend more money which is it’s primary source of income but even staying solvent was becoming a challenge. If money is stuck in the system and doesn’t come back to banks, then overall economic growth takes a backseat.

Why did this happen?

FY 2008-2013 was an era of stalled projects, immeasurable scams (2G scam, CWG scam, coal scam) and needless delays in executing projects which resulted into a standstill. Yet, the world was changing. Economic environment had become far more dynamic for India to be standstill. In other words, India did miss out.

So how is it connected to banks?

Companies take loans from banks to execute projects. If these projects get stalled for no reason (Tata Nano, Singur) or Government doesn’t allocate projects (2G spectrum scam) or there are unnecessary delays in obtaining licences to execute project (unease of doing business) then money gets locked. Also, this gives rise to morally incompetent people who float companies just to obtain loan and run away somewhere far in London, England while having their favourite drink. The whole eco system starts to breed unethical, fraudulent and immoral behaviour.

Banks which have lent money has a hard time to recover those loans. Safe to say, unhealthy. As a result, banks cannot make fresh loans to deserving projects or those projects that need of the hour. As there is lack of credit in the system, entrepreneurs are discouraged to take up more projects. As a result, no improvement takes place. Infrastructure and transport remain the same, worse off on a global scale a country tends to regress. Confidence in the system is lost.

This gives rise to a vicious circle.

In such a scenario, banks first need to recognise assets that have gone bad. Which determines the extent of fresh money required by them to start the process again. Now, banks start to look at government (one and only saviour). But, government makes money out of tax collections from citizens. Infusing honest tax payers money to cover incompetent businessmen’s bad loans brings about a negative mood to honest tax payers, especially salaried class.

This has given birth to a new challenge for the government.

If they borrow money from outside, fiscal deficit (revenue less expenses) widens as they have to pay back compulsorily regardless of bank being stable or not. If they use taxpayers money, sentiments are hurt and their chances of being re-elected become grim. So what to do?

Because of unhealthy lending structures, Public Sector Banks have suffered a lot more than Private Sector Banks. Hence, this recapitalisation is for Public Sector Banks only.

Dear readers, if you have any further query on Recapitalisation please feel free to write in the comment section below and we will resolve the same.

– Jinay Savla

Thursday Trivia ~ Financial Thumb Rules to Remember (Part 1 / 3)

‘Millionaire! One more time I hear this word from your mouth and you will sleep on couch tonight.’ Malvika was really angry this time. Over the past few days, Rohan had become obsessed with becoming very rich. Not an unusual obsession for someone in their early 30s. However, what Rohan could really not figure out is ‘how to be a millionaire’. He was working in a multinational company with a salary package that was appropriate for his age and experience.

‘But I didn’t say anything. How did you know I was thinking about it?’ asked a perplexed Rohan. Malvika amazed at Rohan’s response said, ‘I’m your wife, I even know the facial expression when you don’t like the food I make.’ Rohan tried to laugh but decided it was not appropriate for the moment. ‘Have a look at this Thursday Trivia, it might help you to get an answer to your million dollar question.’ said Malvika with a smile. Rohan couldn’t believe what he had just heard.

‘Thank you so much my dearest!”, Rohan jumped out of his seat and hugged Malvika.

Like a curious child, Rohan browsed through the blog. He found various articles on personal finance and started taking notes. While his primary objective was to learn about certain thumb rules first.

100 minus Age Rule

This rule tells future millionaires how much of their portfolio should be in equities. Thought behind this rule is as the person gets older, his ability to take risk reduces and would not prefer a large swing in portfolio value with fluctuation in equity markets.

Rule : 100 less (Current Age)

Rohan is just 30 years old. He was happy that he could invest 70% of his portfolio in equities. Being young could mean, he would be able to take more risk and realise his dream faster.

“My favourite rule of thumb is (roughly) to hold a bond position equal to your age – 20 percent when you are 20, 70 percent when you’re 70, and so on – or maybe even your age minus 10 percent.” – Jack Bogle

Rule of 72

This particular thumb rule is used to estimate the number of years it would take to double an investment on expected rate of return.

Rule : Number of years to double = 72 divided by rate of return

Rohan quickly realised that current rate of fixed deposit is 6% on fresh investments. Hence, it would take 12 years. (72 / 6)

Rule of 114

This rule is used to estimate the number of years it would take to triple the investment on expected rate of return.

Rule : Number of years to triple = 114 divided by rate of return

Rohan was now thinking. If he invests the same money in debt mutual funds with 8% rate of return. It would take him approximately 14 years to triple his investment and 19 years if he invests in bank fixed deposits at 6% interest.

Rule of 144

This rule is used to estimate the number of years it would take to quadruple the investment on expected rate of return.

Rule : Number of years to quadruple = 144 divided by rate of return

Rohan got excited. He thought if he invests in equities expecting 12% rate of return, his investment would quadruple in 12 years (144 / 12) compared to debt mutual funds taking 18 years (144 / 8) and 24 years in bank fixed deposits.

36% Debt Rule

This rule states the maximum amount of loan / debt to be taken by a person including housing loan, vehicle loan, credit card loan, any other personal loan, etc. should not exceed 36% of his monthly income.

Rule : Equated Monthly Instalments = 36% of Gross monthly income

Rohan with a monthly salary of Rs. 1 lakhs quickly noted down that his total EMIs should not exceed Rs. 36 thousand.

Emergency Fund Rule

This rule states a specific amount to be set aside incase of any emergency such as loss of job, illness, business problems, etc. The amount is usually set aside in liquid assets such as savings account, short term fixed deposit or simply keeping enough cash at home.

Rule : 6 multiplied by Monthly Household Expenses

Upon listening to this rule, Rohan understood that he needs to keep Rs. 3 lakhs as Emergency Fund in his bank all the time as his monthly expenses are Rs. 50 thousand.

10% Saving Rule

This rule talks about minimum monthly savings a person must do as per his monthly income.

Rule : Minimum Monthly Savings = 10% multiplied by Gross Monthly Income

Rs. 10 thousand was not a big deal for Rohan to save. He had a big smile on his face while his mind was working at speed of light.

Malvika sat besides Rohan all the while noticing his changing emotions. It was as if Rohan had found a hidden treasure. However, she was aware that all these are merely rules and she would require assistance of a financial advisor to guide them along.

Dear Readers, we will continue to explore rest of the thumb rules with Rohan in our next Thursday Trivia. Till then, please do write in any particular financial thumb rule that you would like to learn about.

– Jinay Savla

Disclaimer : This particular series of Financial Thumb Rules is only meant for educational purposes. We do not in any ways recommend it, as the case may differ for investors per se.

Thursday Trivia ~ Save Tax upto Rs. 3 lakhs – New Provision on Taxation of Gratuity

Section 10(10) of the Income Tax Act, defines Gratuity as a payment made to an employee either at the time of retirement or leaving from job. However, it is given to an employee once he/she has completed 5 years of continuous service. It is considered to be a monetary reward for being in service with the company. Simply, it proves to be a retirement benefit to the employees.

The Payment of Gratuity Act was enacted in 1972. Earlier tax free limit on receipt of gratuity was Rs. 10 lakhs which the Central Government has now increased to Rs. 20 lakhs for private sector employees in an amended bill – the Payment of Gratuity (Amendment) Bill, 2017.

The amendment will be applicable from 1st January, 2016 in line with the norms set for Government employees. Basic exemption limit for Central Civil Services (Pension) Rules, at par with central government employees, which is Rs. 20 lakh.  Before implementation of the 7th Central Pay Commission, the ceiling was Rs.10 lakh.

Revised Rules for Gratuity Taxation as per Section 10(10) of Income Tax Act 

Gratuity paid to Government sector employees is exempt from Tax.

Impact of Tax Benefit

Employees covered under the Payment of Gratuity Act, 1972.

Mr. Ashish has worked for his organisation for more than 20 years now. He has received Rs. 16 lakhs as a gratuity payment.  His last drawn basic salary was Rs. 1.25 lakhs. How much of gratuity should be exempted?

As per the act, least of the following with be exempted.

  1. Rs. 10,00,000
  2. Actual Gratuity Received – Rs. 16,00,000
  3. Last drawn salary*15/26*Number of years of service – (1,25,000 x 15/26 x 20) = Rs. 14,42,308/-

Hence, Rs. 10 lakhs will be subject to exemption and Mr. Ashish would have to pay his tax on balance Rs. 6 lakhs.

As per the new rules proposed in Payment of Gratuity (Amendment) Bill, 2017, least of the following will be exempted.

  1. Rs. 20,00,000
  2. Actual Gratuity Received – Rs. 16,00,000
  3. Last drawn salary*15/26*Number of years of service – (1,25,000 x 15/26 x 20) = Rs. 14,42,308/-

As per the new amendment, Rs. 14,42,308/- lower of the above three will be subject to exemption. Taxable amount deducted from actual gratuity received Rs. 16 lakhs would be Rs. 1,57,692.

For employees not covered by the Payment of Gratuity Act, 1972.

Taking cue from the similar example, let’s calculate if Mr. Ashish’s organisation is not covered under the Act, least of the following will be exempted.

  1. Rs. 10,00,000
  2. Actual Gratuity Received – Rs. 16,00,000
  3. Average Salary * (1/2*Number of years of service) – Rs. 12,50,00/-

Hence, Rs. 10 lakhs will be subject to exemption and Mr. Ashish would have to pay his tax on balance Rs. 6 lakhs.

As per the new rules proposed in Payment of Gratuity (Amendment) Bill, 2017, least of the following will be exempted.

  1. Rs. 20,00,000
  2. Actual Gratuity Received – Rs. 16,00,000
  3. Average Salary * (1/2*Number of years of service) – Rs. 12,50,00/-

As per the new amendment, Rs. 12.5 lakhs will be exempt from tax. Taxable amount will be (Rs. 16 lakhs less Rs. 12.5 lakhs) = Rs. 3.5 lakhs.

– Jinay Savla