When we talk about money, the two things that come to mind are earning and spending. If you have been following this blog, you will know that to enhance the utility of money you have to think beyond just earning and spending and start focusing on investing.
To invest literally means to put money in some kind of a financial scheme or to buy an asset with the aim of generating profit. Some of us get intimidated with this concept and shy away from important decisions needed to enhance the utility of our money. What you need to do is familiarise yourself with some basic financial concepts that will help you analyse any form of investment and nudge you to ask the right question. These concepts can also be applied equally to understand the utility of loans you take.
In fact, they can be applied to your everyday money matters too. Once you accustom yourself to these ideas, your money life will become a lot smoother and you will be able to tell whether the overall outcome of your financial decisions is positive or not.
This is something that works both ways. It means you may be paying interest and you may be receiving interest from a different source. Ideally, the net of what you pay versus what you receive should be positive. Most people in India either have a housing loan or a car loan or both and also prefer parking their surplus money in bank fixed deposits. In the former, you will pay interest and, in the latter, you will receive interest. It’s very rare that the interest you are paying will be lower than what you are receiving. That’s because, the opposite is true for a bank; for their business to be successful, they have to pay out lesser interest on deposits than the overall interest they receive on the loans they give out.
Once you understand this, you have to start looking at how interest impacts you on a net basis. For example, you may have taken a home loan at 8.5% interest per year and you may have invested in a fixed deposit at 6.5% interest per year; this effectively means that on a net basis you are paying 2% more than you receive every year.
Don’t ignore this basic calculation, especially if you have multiple loans.
If your loans are always going to be more expensive or higher interest paid out than your deposits or investments then your net margin will be negative and hence, you will always be paying more on your loans than you receive from investments.
Ideally, you should aim to have a mix of investments which helps you exceed the value of your interest paid as a cost on any loans.
This is a very important concept in finance and simply relates to the ability of money to multiply at an exponential pace. Compounding happens both with what you receive in an investment and what you pay in a loan. While the former is welcomed, the latter is definitely avoidable.
Any loan or overdraft where your interest is compounding will mean that what you pay as interest will simply keep increasing every year unless you repay the principal.
This is what happens with a credit card overdraft; the interest applied compounds every month. For example, if your unpaid dues are Rs 10,000 and there is a 3% interest per month on that amount, in the following month, you will owe the credit card company Rs 10,300. Assuming you don’t repay the overdraft, at the end of the year with the compounded interest you will owe Rs 14,257 as opposed to Rs 13,600 if it was simple interest. In compounding, there is additional interest charged each month not just on the amount that you owe but also the monthly interest that is calculated and hence, the amount payable increases exponentially.
When it comes to investing you want to embrace compounding; you want to earn interest on interest or profit on your profits because that will increase your gains over time.
Hence, to make the most of your investment always look for options where you can take advantage of compounding returns and avoid this same compounding when it comes to contracting the terms of your loan.
Every financial transaction has a cost; whether you are investing or taking a loan you have to take the cost into account before making your decision. As they say, there is no free lunch. When it comes to loans you take, interest paid is a clear cost, however, there are other charges such as processing fees which also you need to be aware of. When it comes to investing, there is a cost or an expense attached to the financial product. Usually, for market-linked investments like mutual funds, stocks, bonds and so on, the cost is known and published. For Government backed investments like post office schemes and provident fund, there is no cost and for bank deposits, the cost shows up only as a penalty for pre-payment. Government-backed schemes don’t have a cost because they are meant to encourage savings and bank deposits are as much a benefit for the bank which lends the money forward as they are for the depositor.
For any other investment, if you are told that you will make superior returns with no costs involved, you have to question that. How can the return come without there being any cost? Costs are there either to cover administrative expenses or management expenses where the financial product is managed by professionals.
Hence, don’t be too trusting when there are no costs attached to financial products.
Understanding these basic concepts will help you manoeuvre financial matters with clarity of what to expect in return.
Always try to have your net interest as positive to ensure you are not paying more than what you are earning on investments. Don’t be fooled by a low-interest charge, if it is compounding. Look for investment opportunities where you can achieve maximum benefit from compounding. Lastly, remember to question all returns that come free, there is always some cost involved and you don’t want that to be the cost of losing your money.