This young couple I met last week had questions that can easily be classified as some of the most commonly asked. Should we continue to pay the high premium on insurance policies we have taken, in order to save tax? Should we buy a house and pay the EMI instead of rent, so we can own assets early on? Some personal finance questions arise again and again, since decisions have been made without thinking through the first principles.
Consider the decision to insure. A young couple needs insurance for one primary reason: they do not have enough assets to fall back on, in case there is a risk to the regular income of the household.
When one begins to earn, there is a lot that depends on that income, leaving a small portion to build assets for the future. Insurance is the primary protection for a household, should that income come under risk due to a terrible event like death or disability.
However, as the couple grows older, they are able to set aside more and more, and by the time one hits the sixties, the income stream ends and there is nothing that needs to be protected.
Hopefully, assets have also been built over that time to fall back on. That is why a simple and inexpensive term insurance that offers cover through the earning years until one retires, makes sense for most households.
But making that decision is difficult when one forgets the primary purpose and begins to think as if insurance contracts were meant to be investments. When we begin to ask why we should be paying a premium for potentially getting nothing in return, we have completely missed the point.
But that kind of thinking leads insurance providers to think up complicated products that mix insurance and investment, and create insurance products that will also provide some payoff to the investor.
Not everyone is able to sift through the complexities of how the premium paid is allocated towards insurance and investments, and make an informed choice regarding costs and benefits, The lure of tax saving is enough to nudge one towards buying products that are unsuitable, and soon enough many like the young couple in question abandon the product due to inability to pay the premium, or worse, close the policy with steep losses.
An investment should perform well to merit further commitment of money. If one buys a 15-year policy and finds that the return is a low single digit, or is much below other investment products that one is buying, there is little merit in continuing it. It is better to take the loss and invest the money elsewhere.
However, it is foolish to stay uninsured. A simple term policy will offer the protection that the young household needs, until sizeable assets are built.
Now consider the housing loan and the benevolent view of the EMI. To many simple families, owning a house would not be possible if bank loans were not available and if the facility to pay EMIs were not available.
The tax concessions on the housing loan make it even more attractive to couples who believe it would be better to pay the EMI and own the asset rather than pay the rent as an expense. But it may not be as simple as it seems.
Consider the simple principle of financial leverage that is used by most businesses that borrow money to fund their assets. A businessman puts in Rs 50 of his own capital, Rs 50 of borrowed capital and buys goods worth Rs 100. When we sells it for say Rs 120, he makes a 20% profit.
However, if the loan came at an interest rate of say 10%, he pays Rs 5 as interest on the loan of Rs 50, and makes a return of Rs 15 on his capital of Rs 50, which is a 30% return. His business return of 20% is enhanced to an investment return of 30% since he used borrowings to fund it. That is the benefit of leverage.
In the case of our young couple, they also may have put in a smaller portion of the capital in buying the house, and used borrowings to fund the rest of the asset. However, as long as they live in that house, they will make no rental income, nor will they earn any gains from selling the house.
In other words, the appreciation in the value of the house is only a halo effect that can make them feel good about the asset they own, but the money is locked into the asset anyway. Unless one is in the business of buying and selling houses, hopefully at a profit, there is no merit in rushing to take a housing loan.
They would end up with an EMI that is much higher than the rental equivalent for the house they intend to buy, thus reducing their ability to save and invest in other assets. If they consider the loan amount and the repayments that they actually made, they will find that they have incurred a huge cost on an asset, bought with the intention of saving on rent.
The equity that they believe they have in the house, in terms of the appreciation in value of the property that can happen with time, will translate into actual gains for them only if they realise it, or use it to take a loan for some other beneficial purpose. In many cases, the psychological security about owning a house outweighs the financial merit of investing too much too soon into a large immovable asset.
The primary financial goal for a young couple should be to build investment assets that can be easily accessed should a need arise, since the early years include several new commitments including the one to begin a family.
If the mother of the child chooses to take a break from working, the household would have to deal with lower income and higher expense. Neither the insurance policy, nor the house will come of any use in that situation. The premium and EMI will turn instead into painful burdens.
The challenge for many young earners is to reign in expenses and develop the saving habit. Committing to insurance premium and EMI is not the ideal way to get there. Beginning a systematic investment plan that puts aside half the income of the household, might be a better choice. An investment corpus will generate supplementary income, while also being available to draw upon in case of need and to replenish when possible.
(The author is Chairperson, Centre for Investment Education and Learning.)
Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.