Why you should repay your loans regularly

Most of us would have taken loans at some point in our life. Either an education loan for paying your college or a loan for your vehicle or you would have bought your dream home. Other popular form of debt is credit card.

Whichever method you borrow money from a bank or a financial institution, do make sure that you repay it regularly and and start at the earliest.

First reason is simple, every month you miss your regular payments, the amount you end up paying would begin increasing. Money always grows exponentially – especially if owe it to others. And the penalty you pay for late payments also eat into your savings.

Second reason is something that is even more important – your credit score. Your credit score is basically a number from 300 to 900 given by an organization called CIBIL. Whenever you apply for a loan or credit card your bank asks CIBIL for your credit score and credit report. And all banks/financial institution sends a report of your loan repayment regularly – so your score is updated frequently.

If your credit report is good, you get your loan and at better terms. If your credit report is bad, you may get need to pay higher interest rates and worse your loan application may even be rejected.

CIBIL calculates the credit score based on 5 important parameters and each parameter has got its own weightage:

  1. Type of credit used – 10%
  2. Recent search for credit – 10%
  3. Length of credit history – 15%
  4. Credit Utilization – 30%
  5. Payment history – 35%

If you see the last parameter, you can see that your payment history has the most weightage. Which means, every time you miss out on the monthly payments, your score falls significantly.

The reason for this is plain logical. Lets say you have two friends Alice and Bob who both have borrowed Rs.10000 from you. Alice returned the money in 5 installments of Rs.2000 each without any default. Bob on the other hand returned Rs.2000 only for the first month and paid the remaining installments only after a year. If they both come and ask for money again, Who would you give your money? Naturally Alice – because you don’t want to take the risk again. Banks are similar and they don’t want to risk their money by lending to someone who are prone to defaulting on their repayments.

And this means, repayment of all kinds of credit you have utilized. It could be the monthly EMIs you pay for your car/house loan as well as the monthly credit card bill. Lot of people pay just the minimum balance on their credit card bill. That is a very bad, bad thing to do. Credit cards have a very high interest rate than your traditional loans. 

So make sure you have a plan to repay all your loans as regularly as possible and if you can even decrease your expenses so you have extra cash to pay a little bit extra. This is the first step which you must take to fix your financial life.

You may ask is it possible to know what your credit score is? The banks get it, why can’t we? Tomorrow we will see how to apply for and get your credit score within a few minutes.

How to start your financial life

After reading my previous posts you are saying “OK! I agree. Let me get my investment stuff started now. How do I begin?” Alrighty then.

For this article, I am assuming that you are in your early 20s and just completed your college education, got a decent job and started earning a good salary. Even if you were working for a few years and haven’t invested much in anything, you can use the information here and have more money when you retire than what you expected to have before.

Let me list out the things we will be doing, in the order of importance. Don’t worry if some terms are not clear, I will explain each step in detail in separate articles in the future.

The best thing about this investment strategy I am suggesting is that its all set to automatic and you will have to spend less than a few hours every month to just check that things are working as planned.

Spend your first month’s salary buying everything you wished for during college

If you were employed for a few years already, then you would have already done this step (many times I think). You can skip to the next section.

Yeah, you read it right. Spending money is good, especially now that you got your first paycheck you can buy everything you wished for. While you were studying, you would have wished to get the latest mobile in the market but were stuck using some old model (I got myself a nice mobile with my first salary). Or you might want to get some new dress for your mom, a watch for your dad. The first salary you get is emotional for most Indians and they would want to spend it for their parents first. Good, that is great to hear. And your friends would ask for a treat as you got a good job and you might like to party.

Do it all, use your first month’s salary for all these things you wanted. If you want, take the second month’s salary too, because once you have started to save money for your future, it would not be easy to stop these investments and its not advisable too.

Repay your education loan

Most of the middle class Indian kids get an education loan from a bank for their college education. And their loan repayment begins as soon as they come out of college. It is very important you repay the loan regularly without any breaks.

If you were working for a while and got any other loans (personal/car/home) make sure you repay them regularly. If you find it hard to repay your loan, discuss with your bank and negotiate the terms. You can even ask to increase the repayment period and end up paying less money per month.

There are various reasons for regular repayment like improving your credit score to making sure you don’t lose money because of late payment penalty. Remember the “compounding effect”? It works for debt too. It increases your debt exponentially if you don’t start paying it now. So it doesn’t matter if you invest your money now, paying off all your debt as quickly as you can is more important.

Get an Insurance

Life Insurance is very important and I would say mandatory if you have someone depending on you for their expenses. It could be your parents, your younger siblings still in school, your spouse, your children. If they can’t earn money on their own, they are a dependant. You need to protect them in case you die and they don’t have any other source of income.

In most offices there would be some employee who is also an LIC agent and would try to sell you a life insurance policy. They would use some terms that you won’t understand like endowment policy, moneyback policy, etc.

My advice regarding those: Stay Away from them. Run, like your life depends on it. The reason is traditional policies that they suggest is as good as throwing away part of your money into the fire. In fact when your policy expires (somewhere in your 40s) or when you die before the policy expires you/your dependants would be getting a very low sum assured that would be good enough for just a few months of expenses. The money you put in these traditional policies don’t grow with inflation, so the value of your money erodes every year. And your dependants would be financially stuck when you are no longer with them paying the bills.

In future articles, we will look at a better way of insuring yourself (and also why you really need insurance) using something called Term Insurance. This is so much cheaper than traditional insurance plans, which means you have extra money remaining which can be put in investment products which return better interest rates which can actually beat inflation.

Apart from life insurance, you would also need to take health insurance which will pay your hospital bills when you get sick. Most companies make it as part of the package, but if you are working for a very early stage startup which doesn’t have these perks, you need to take one. Remember you need to take health insurance for your dependants too and there are various different types of policies that would help.

Investing for your retirement

This is the part where you invest your money for the long term so that it grows to a huge amount that you can live without any problem after your regular income stops. Till now we have only repaid our debt, insured ourselves against death. We will look at various investment products and strategies which will earn you a nice extra money in the long run. There are various safe products like PPF, Fixed Deposits, etc., and riskier products like putting your money in the equity market which does provide higher returns. Most companies which has more than 20 employees already invest a small amount in the Employees Provident Fund which is a great investment.

There are other classes of investments like Bonds, buying Gold, buying land/house, etc. Each has its own levels of risk and reward. And some classes of investment follow a cycle of highs and lows which need to be understood before you invest into them. Remember every form of investment is risky, only there are various levels of risk. The more riskier an investment is, the higher the reward. The less riskier the investment is, lower the reward.

If you need to beat inflation, you need to take a little bit of risk. And how to protect yourself against the risk? By investing in low risk products too. So your overall portfolio risk decreases. This is called portfolio diversification and will help protect your money when there are sudden falls in the equity market like in 2009 or the recent drop in gold prices. When others are worrying about their hard earned money lost, you will be sitting comfortably with your money growing and earning you a handsome return.

Saving for short term goals

piggy-bankEveryone has short term goals like buying a nice bike/car, going for vacations to some exotic places, buying a nice camera, the latest game consoles, etc. These are important to have as it will greatly improve your lifestyle and also help remain sane after working more than 9 hours in a cubicle. The 10 day trip you take to some foreign country will help you to meet new people and open up your mind. You should go out often and live your life too.

You need to set up separate accounts for such short term goals and put in a small piece of your money in it every month. If you intend to go out of country every year, just calculate the entire cost of the trip, divide it by 12 and put in that amount in a separate account every month. End of the year you will be sitting on a nice pile of money that you can use to pay for your trip (or the latest gadgets/car). And these accounts also return a nice interest rate so you get slightly more than what you put in for the whole year.

If I keep investing my money, when do I get to spend it?

Ah, right. We have at last got to the part – spending your money. You may be wondering why I talk about it at the last. Because, the right way to handle your finance is to invest your money first and then spend the rest.

You may complain that you have to have your house rent, daily expenses, food, travel, etc. I know they are essential and the best part is most of these expenses are predictable. You know how much your house rent is, how much you spend on your groceries, travel, eating out, etc. Remember that was the first exercise we did two days back.

Now is the time to take a look at that sheet of paper. Lets say you earn Rs.25,000 per month and your monthly expenses are about Rs.20,000, then your remaining Rs.5,000 is a surplus that can now be invested. So we will make sure we have a system setup which will take away this Rs.5000 at the beginning of the month automatically. I prefer within 3-5 days of your salary being credited. If you get your salary on the last day of every month, set up all automatic account transfers to various accounts on the 3rd to 5th of the month. It could be your loan repayment EMI, transfer to PPF, any deposits you make, etc.

If your money automatically goes to the different investment accounts, you don’t see it and you wouldn’t miss that money. So it forces you to spend only the remaining money and automatically have a tighter control over your budget, while your investments grows without you lifting a finger.

If you noticed, I didn’t mention anything about cutting down your expenses – yet. You can maintain the similar lifestyle you have today and also invest for your future. It isn’t that hard. Of course, if you are having lot of debt like credit card and personal loans, we will have to make some adjustments to your lifestyle a bit, but soon within a few years you will be debt free and can save more.

Planning your financial life isn’t that hard and everyone should begin investing as early as possible. With the online banking and automated transfers, it has become very easy to invest today than it was a few years back.

Now after reading this big essay, you would want to know more details about the various investments products and in which you should put your money in. We will discuss all these in details in future posts one by one.

So tomorrow, you will learn about repaying your loans and why you should repay them. We will also see what your credit score is, how your previous loans affect the score and how the score will affect your future loans.

Why you should start Investing early

Yesterday you identified where your money is spent and next we will see at how you can save money for your retirement.

You say “Retirement???, I am just 21 years old and have just started working. Why should I plan for retirement. Its decades later and I would definitely get multiple pay hikes 10 years later than what I earn today. Why can’t I start my savings then?”

The answer to that is “Power of Compounding” and it is equivalent to a magical force in the field of finance – both in terms of investments and debt. Let me explain it with an example.

Investing Rs. 1 Lakh every year for 37 years

Say you (aged 21 in 2013) got a decent job this year and you start saving exactly Rs.1,00,000 every year till your retirement (assuming you retire at the age of 58 in the year 2050) for 37 years in total. So you would have invested Rs. 37 lakhs in total and the investments returns say 8% consistently and without any risk. How much do you think you will have in your hand in the year 2051?

You could take a guess, but if you really sit down and calculate it you would find out that you would have a cool Rs. 2,19,31,595 – thats Rs. 2.19 Crores. I hear you say “What? Crores? Impossible. I just put in Rs. 37 Lakhs and crores? Really? Crores? Wow!” But it is true. That too I put in a very safe and low interest rate of 8% per year and there are ways to get better returns too. And imagine how much more you could earn if you could increase the amount invested every year.

The best part is you do not move a single muscle to earn this extra money. It is all done by your bank/investment automatically without you even thinking about it. It is like free money and its all yours.

Starting late by 1 year

Now lets say you didn’t invest the first year and started your investment from year 2 (for 36 years in total). How much would you get back? Rs. 2,02,07,032. Let me put it differently – you LOSE Rs. 17,24,563. That is the amount of money you lose because you missed the opportunity to save just Rs. 1 lakh in the first year. Thats how much that 1 lakh could have grown in 37 years.

1 lakh becomes 17 lakhs. Magical right?

Starting 10 years late

Now lets go with your idea of starting to invest after 10 years (total of 27 years). Do you really want me to show the numbers? You would not like it, but the numbers don’t lie. You would have Rs.94,33,883 only. In other words, you lose almost Rs.1.25 crores by starting a decade late.

Even if you double the money you put in you would be be losing more than Rs. 30 lakhs if you start 10 years late. Not a good idea right?

This example is pretty simple and you can try running the numbers in Excel yourself. But I have created a google docs spreadsheet which you can copy with the formula or download it. You can even change the interest rates a bit and see how much more you can earn.

So there you have it, a reason to start your investment early. Now tomorrow lets see how you can plan how much to invest and how to start it.

Guess where all your salary goes?

Apart from entrepreneurship, programming and technology one of my primary interests is money and how it grows (or loses) its value. I haven’t written about money or handling personal finances before in any of my blogs, but I think it deserves a decent space where I can share my knowledge. All articles about personal finance and the various investment strategies or products will be specific to India.

First before suggesting new ways to handle your money and your investments, you should first understand where all your money goes right now. If I asked you how much you spent on movies last month? Or on dinner in restaurants? You would probably say “I don’t know, I guess Rs.1000? Was it Rs.1500?” When you don’t know how much money comes into your account and how much goes out, it gets very very hard to keep track of things and this pushes most of us into debt.

I am just going to ask you to do two very simple tasks for today. It hardly takes 20-30 minutes. Do this and you would get lot of insight into how bad (or good for some people) your money spending is.

1) Guess how much percentage of your income you spend on different categories every month

Take a sheet of paper and on the first line write down your monthly income (could be salary or your total income if you are self employed). Next write down the various categories under which one could spend money, eg: rent, loan repayment, credit card bills, electricity, phone & broadband, food, groceries, entertainment, medicines, dresses, gadgets, fuel, etc. Try to think of as much categories you can and guess how much percentage of your total income you spent.

Remember its just a guess and shouldn’t be exact. You shouldn’t try to write the exact numbers from your bills (that is the second part). Some numbers like rent and insurance premium will be easy to remember and you can write them down easily. The others like food, movies, medicines, etc., you will have to work with a guesstimate. Thats why I am asking you to write down percentages.

2) Write exact amount you spent last month under these categories

Take out your credit card bills, telephone bills, electricity, medicine receipts, bank account statements and write down the total you spent last month alone. Try to be as accurate as possible. The more accurate it is the more easier it is to identify where your money leaks.

Write them down on the side along with the guesses. Once your numbers are done, write down the actual percentage you spent last month against each category. Notice the difference between what you guessed you were spending vs what you were actually spending?

guess and actual spending

Both the above steps are necessary. You should know the difference between how much you “think” you are spending vs how much you “actually” spend. Once you realise this difference, you can easily make changes to how you spend on things which matter. So go ahead and finish these simple steps today and be ready to save more money for your retirement.

And in my next few posts I will be talking about how to funnel your money in through the right channels so that you can save enough money for your future as well as spend on the present day’s necessities.