We have to often deal with many interesting tight-spots as far as our day-to-day money matters are concerned. So how do we choose the best alternative?
What are the pros and cons to be weighed before saying yes to one of the options?
A. Fixed rate or floating rate home loan
Home loans are generally long-term in nature, spanning almost 1-2 decades. Predicting the interest rates over such a long period is, naturally, impossible... in fact, futile. Therefore, stop worrying about how the interest rates will behave in the future.
Instead, shift the focus to your risk bearing capacity.
Go for fixed...
Financial prudence suggests that the total EMI should not be more than 40-45% of your monthly take-home pay. Therefore, if your EMI, at current interest rates, is already around 45%, any hike in the interest rates is going to put you in the danger zone. Hence, it would be safer to opt for fixed rate loan.
Remember, this would be about 1-2% more expensive than floating rate loans. But, it would
be prudent to pay this extra cost for the security that you get. (You always have the option to prepay and switch to a cheaper loan if in future the interest rates were to fall sharply).
Go for floating...
But assuming that in your case this ratio is only 25-30%, then you have the cushion and the capacity to absorb the risk of higher interest rates. Hence, you can take a chance with a floating-rate loan.
As mentioned earlier, this will be cheaper than fixed-rate loans. (And if the interest rates start becoming too expensive, you can always switch to fixed-rate loans later.)
(Borrowing from E.L. Doctorow's quote) - It is like driving a car in the night. Though you can see only maybe 50-100 metres ahead with the headlights, they are sufficient for you to travel safely for hundreds of kilometers.
B. Direct equity or Mutual Funds
Investing in the stock market through a Mutual Fund is a safer option due to diversification. The corpus of a typical fund is normally invested in about 25-50 stocks. Therefore, while some stocks may do well, some average and some bad, overall you can expect to make ‘reasonable’ returns.
However, suppose you have the expertise to invest directly and you keep your portfolio concentrated to a limited number of potentially high-growth stocks (Warren Buffet's investment strategy). Then your returns are likely to be far better than the reasonable mutual fund returns.
The dilemma — should you go for reasonable returns or try for something better?
Go for direct equity...
Equity investing carries high risk; more so if it is a concentrated portfolio. As such, you may go for direct investing provided you have the capacity to withstand a sharp fall in the value of your investments.
Go for mutual funds...
If not, it would be prudent to play for the reasonable — but comparatively surer — returns through the mutual funds. By the way, even the reasonable return of 15-17% p.a. expected of MFs, is not bad at all; and definitely worth the risk.
[Note: All this, however, is subject to an important preconditions — (a) you must be an expert in buying / selling shares, (b) matching the qualifications and experience of a professional fund manager; besides, of course, (c) having the time / resources to conduct thorough research and closely monitor your portfolio.]
C. Insurance or no insurance
Insurance policy protects your family from financial hardships in case of any unfortunate eventuality. This, however, comes at a cost. You have to pay premium every year to maintain the policy.
Given that the probability of such events is not very high, you debate — should I take a chance and save this cost or do I play safe even if it costs some money.
Here your net investments (= assets – liabilities) may provide the right answer.
No insurance if...
If your family’s income (excluding your income) + the returns from your net investments work out to about 70-75% of the present total income (including your income), you could possibly skip buying an insurance policy; and save on the premium charges.
Insure if...
However, if this works out to say around 50%, you could consider buying a some cover.
But if it is only 15-20% and your family is predominantly dependent on your income, it would be prudent to take proper insurance cover.
[Note: If you need life cover, consider only the Term Plan. This is the cheapest and simplest way to insure yourself. You can ignore all other types of life covers such as endowment, moneyback, wholelife and ULIP.]
D. Foreign trip or Personal loan prepayment
You have received an unexpected bonus. It has always been your dream to vacation in Singapore with your family. But, given the expenses involved, it has remained an elusive dream till now. This, therefore, is a great opportunity to fulfill your dream as this money was anyway not expected.
However, on the other hand, you have a personal loan to pay off.
You ponder — will it not be better to repay the debt and save the huge interest expense. Or this time should I live my dream?
Prepay loan...
For personal loans, it is recommended that the EMI should not exceed 10-15% of your monthly take-home pay. Therefore, if you are closer to or higher than this number, you may be better off repaying the personal loan from your bonus.
Enjoy your foreign trip...
However, if this ratio is only say 5%, have a nice trip.
[Note: I have seen instances where people have money lying in FDs and earning 8-10%, while they are paying 12-15% on their loans (or even 30-40% on their credit card outstanding balance). This makes no financial sense. If you have a similar situation, immediately break your FD and prepay the loan.]
