Common Misconceptions about Mutual Funds

Mutual Funds are an easy way to invest your money and let professional fund managers handle the hard part of choosing the right place to put your money in. But there are numerous confusions and misconceptions around mutual funds that I want to clear in this article.

Myth: Mutual Funds is just for equities

Fact: Mutual Funds are not only about investing in stocks or the equity market. There are different types of funds which are classified based on the underlying asset classes they invest in.

  • Equity Mutual Funds – invest mostly in equities (note mostly. SEBI says minimum it should have 65% in equity)
  • Debt Mutual Funds – invest mostly in debt or fixed income
  • Liquid Funds – invest in very short term (< 91 days) instruments like treasury bills.
  • Gold Funds – they invest in gold and track the price of gold.
  • International Funds – they invest in stocks of international companies and track foreign stock indices like Nasdaq.

People who want to invest in any kind of assets can invest using Mutual Funds and get the help of professional fund managers to handle their money.

Myth: A mutual fund with lower NAV (Net Asset Value) is cheaper and better

Fact: A fund’s NAV doesn’t matter because it represents the market value of all the fund’s investments and doesn’t depict the market price.

To understand it better: Lets say Fund A and B invests in the same portfolio of stocks. Only difference between then is the NAV of fund A is Rs.10 and fund B is Rs.100. After a year the stocks increase in value by 10%. So the NAV of fund A will be Rs.11 and of fund B will be Rs.110.

NAV of two funds

So your money grows by 10% and it doesn’t depend whether you invest in fund A or B.

Myth: Mutual funds are long term investments only

Fact: There are mutual funds which are suitable for short term investments too. They are funds which invest in bonds or even treasury bills which are protected for returns for a short duration. If you are in the highest tax bracket parking your excess money in Liquid funds or ultra short term funds are better and tax efficient than fixed deposits.

Myth: One needs lot of money to invest in Mutual Funds

Fact: No. You can invest in mutual funds even if you have just Rs.1000. And you can start an SIP even with Rs.500/month. Compared to investing in real estate or Gold, this is one of the best investments which doesn’t require lot of money.

Myth: Any investment in mutual funds enjoys tax benefits

Fact: Only ELSS (Equity Linked Savings Scheme) funds enjoy tax benefits under section 80C. And they too have a limit of Rs.1.5 lakhs per year. Remember any investment made in ELSS are locked in for 3 years.

Myth: Invest in lot of funds to properly diversify

Fact: Investing in lot of funds doesn’t help. Remember a fund just a collection of different stocks that a fund manager chose to invest in. Most of the funds would have a lot of overlap in the stocks. Also over diversification also hurts your returns. It is better to invest in only 1 good fund under each fund type.

Multiple funds

I personally am invested in 1 ELSS, 1 Large Cap, 1 Mid Cap and 1 Small Cap fund. There is no use in investing in 3 or 4 funds under each category.

I hope this has cleared some common myths surrounding mutual funds. Now the only problem is how to choose the right fund and how to invest in it the right way. Will cover it in future articles.

How to repay your credit cards instantly

In my last article I explained everything about credit cards and how easy it is to fall into the debt trap. If you haven’t read it, go and read it first. Two basic things should be obvious from that article:

  1. Interest Rates on credit card debt is one of the highest ever for an individual
  2. Paying just the minimum balance every month will take you years to clear off your debt and you lose a lot of money by paying interest.

We will take the same example of a credit card having an outstanding balance of Rs.1,00,000 and 3.25% interest rate per month. Lets also assume that your salary is not enough to repay the entire debt in a single month after all the expenses.

So you were paying only the minimum balance of Rs.5000 per month. But you saw that it will take 33 months to repay the entire debt. What if you wanted to repay it sooner? For that to happen there are two factors that play a role here:

  1. The bank should reduce your interest rate (Yah! like that is going to happen so easily)
  2. You pay slightly more than the minimum balance every month. With a little bit of proper budgeting, this is easier to manage and is within our control. Lets take 3 examples and see how each works out.

Lets take 4 possible scenarios:

  1. You are only able to pay the minimum balance of Rs.5000 per month.
  2. You are able to pay 10% more than the minimum balance. So instead of paying Rs.5000, you can pay Rs.5500 per month.
  3. You are able to control some of your expenses and can pay back Rs.10,000 per month. Double of your minimum balance.
  4. You got a raise and also cut down on your expenses. Now you are able to pay back Rs.20,000 per month.

You can plug in these numbers in one of the numerous calculators online or can check out this graph that I drew with the calculations already done.

Amount vs Time taken to pay
Monthly Amount vs Time taken to pay
Option Monthly Payment Num of Months Interest paid
A 5000 33 Rs.64,133
B 5500 28 Rs.53,711
C 10000 13 Rs.22,924
D 20000 6 Rs.10,972

This shows that even a small 10% increase in the monthly payments helps a lot by saving you 5 months and more than Rs.10000 as interest paid to the bank. If you have credit card debt make sure that you are putting in as much money as you can into your monthly payments.

What about very large outstanding balances?

There are numerous people who got too deep into the credit card debt trap, that it would take them many years to finish repaying their bill. What to do in those cases? Here are 7 ways that you can get out of your credit card debt almost instantly.

Credit Card Repayments

1) Break your savings/investments

If you have money lying around in your savings accounts or fixed deposits, break them and use that money to repay your credit card bill. Your fixed deposits might earn you 8% per annum. But remember your credit cards are making you lose 39-42% per annum. You will definitely be profitable by paying off your debt first than not breaking your fixed deposits.

Also remember it doesn’t have to be just FDs, but it could also be money that you have invested in mutual funds or bonds, etc. As long as you keep losing money servicing your debts, any investments would give you a net negative return on your networth.

2) Take a loan from friends/family

If you have a good relationship with friends or family, you can take a small loan from them to repay the bill first. Most friends/close family would give you money for zero or very low interest rates. Even if you agree to pay a bank FD rate to them, they would be profitable and you also would get a loan at much lower rates than banks.Win-Win situation to both parties. Also, it is easier to convince a close friend or family member.

3) Take a personal loan from your bank

Go to the bank with whom you have a good relationship and talk to the manager to get a personal loan for the amount you have to repay. The interest rates for personal loans are much higher than what you can get a friend to agree to, but it is definitely lower than a credit card debt. Personal loans are at a rate of about 16%-20% per annum and you end up paying half the interest rate than a credit card.

If your credit report is bad and your CIBIL score is too low, you can go for a secured loan. You have to give a collateral to the bank and get a loan. You can also try gold loans or top-up loans if you have a home loan already.

4) Convert Credit Card debt to EMI

Most banks gives you the option to convert Credit Card debt into EMIs which has a much lower rate than the APR – usually 13%-16%. You can also chose to convert it to an EMI immediately after purchase and you also get different repayment tenures like 3/6/9/12/24 months.

5) Balance Transfer to a different Card provider

Lot of banks provide a balance transfer facility to get new customers. All you have to do it become a new customer with a bank and the new bank will pay off your old credit card fees and will transfer the outstanding balance to your new card account. And as an incentive for you to join a new bank, they give interest free period of few months and very low interest rate for initial 6 months.
Eg: SBI offers a 0% interest for 2 months or a 1.7% interest/month for 6 months. Depending upon your balance to be paid and your repaying capacity you can choose whichever plan suits you.

6) Negotiate a lower interest rate

Remember I said lowering the interest rate means you get to pay back sooner? You can go to your bank and explain your financial situation to the manager and try to negotiate a lower interest rate. You have to convince them that you are willing to pay and intent to do it fully within a few months once your financial situation gets better, you can shave off a few percentage points off the interest rate. It is a long shot, but you can try it.

7) Credit Card Settlement

If all else fails and you think you can never completely pay off the entire balance, you can go in for a settlement. You have to go to your bank and negotiate a settlement amount (which is lesser than the outstanding amount). Once you pay off the settlement amount, your balances are cleared and you are free to go. Except this involves the bank reporting to CIBIL about the settlement and it will severely affect your credit score. Always use this as a last resort.

Be warned, all these are solutions only if you are unable to repay the balance easily. These solutions shouldn’t give you some sort of safety net to get into the debt trap.

3 Golden Rules to using a credit card

Always remember these 3 rules when using a credit card:

  1. Never spend more than you can afford.
  2. Pay your credit card bill at least 3 days before due date. Better enable auto debit facility from your savings account so you don’t have to remember it.
  3. Never lose money by paying unwanted interest rate to the bank. Remember no one has ever become rich by losing money.

Understanding Credit Cards and the debt trap

Credit cards! The smell of a freshly pressed plastic card is like a drug to many. Young people these days spend money using the credit card like it is real cash. They don’t realise that it is a loan that you take from your bank and you are supposed to pay it back with interest (a really high interest rate too).

As of October 2016, there were 2.73 crore credit card holders in India and with all the excess cash in banks due to demonetisation and cashless transaction drive by the Government, this number would increase a lot as banks will now try to give more credit to it’s customers and people get comfortable with online shopping.

credit cards

But first let us understand how credit cards work and the different terminology used.

Interest Free period

Credit cards are a great way to buy stuff without paying the entire amount on the day of purchase. The banks also give the customers a interest free period per month of upto 50 days. To understand that, lets say your credit card bill gets generated on the 5th of every month and your pay-by date is 25th of the same month.

You are buying a TV for Rs.1 lakh on the 6th of January. The seller has delivered the TV and the bank has also paid the seller the money. You haven’t paid the bank yet and your bill will be generated on the 5th of February at midnight. On 6th February morning you will get an Email and SMS about your bill amount of Rs. 1 lakh and that you need to pay it by 25th of February.

As long as you pay the entire amount of Rs.1 lakh on or before 25th February, you have practically gotten free money from the bank for 50 days. Neat right? This is a great way to handle urgent needs and cash flow crunches.

credit card statement
My own credit card statement

I have taken the example from my own credit card statement. The only difference is the amount payable.

Also what is the credit limit? This is the total amount that the bank allows you to spend. Do remember that this isn’t what your spending limit is. Your spending limit is based on how much you can repay and how much you really want to buy. And available cash limit is how much cash you can take out of the card from an ATM machine.

What happens if you keep paying only the minimum balance?

In your credit card statement you also notice in big bold letters that your minimum balance is just Rs. 5000 per month. So you bought something for Rs. 1 lakh and you just have to keep paying Rs. 5000 per month and you would have fully paid it off in 20 months right?

WRONG!

The bank gives you money as loan or credit and for that facility you have to pay the bank an interest. The bank calls that Revolving Credit Facility where as long as you pay the minimum balance for the month, you wouldn’t get into (too much) trouble. Problem is the interest rates these banks charge you.

Interest Rates

Credit cards have the highest interest rates of all the loans/credit that the banks give, because it is an unsecured loan, you don’t submit any collateral to the bank while applying for one. When the bank sales person comes and sells his credit card plans notice how he would say the interest rate is a very nominal (I hate that word) rate, typically something between 2.95% to 3.5%. What they wouldn’t clearly explain is that number is the interest rate you would pay monthly and the annual percentage rate (APR) is that number multiplied by 12. That translates to 35.4% to 42% per year.

APR vs APY

That interest rate x 12 months = APR is a nice and easy number to calculate and the banks usually mention that in their Schedule of Charges section of the brochure in a 10 pt font. But the people who run banks aren’t stupid. Unlike most of us, they know and understand compounding like the back of their hand. APR is just simple interest and doesn’t take it account the power of compounding.

Compounding is a way for the banks to earn more money from your spendthriftiness. To know how much you are really paying, you would have to understand something called the Annual Percentage Yield (APY), also known as Effective Annual Rate (EAR). So the APY will always be slightly higher than the APR.

To understand the difference between APR and APY, lets take a very nominal (there’s that word again) interest rate of 3.25% (which is the average you would be getting as a new customer).

APR: This is easy. 3.25×12 = 39%
APY: We have to use the Compound Interest formula for this.
= (1 + monthly interest rate) ^ number of months in a year – 1
= (1 + 0.0325) ^ 12 -1
= 1.0325 ^ 12 – 1
= 1.467846 – 1
= 0.467846
= 46.78 %

Wow. Look at that number. There is a world of a difference between the APR and the APY. No bank ever tells you this. Who in their right mind would say you would be paying nearly 50% as interest rate every year? Thats why banks stick to the monthly interest rate or the APR (which is a relatively smaller number).

It only gets worse when you have a balance to be paid on your card and are making more purchases. All purchases when you have a existing balance on your card doesn’t get to enjoy the interest free 50 day period. You have to pay interest the day you make the purchase.

Coming back to paying the minimum balance of Rs.5000 per month, can you guess how many months it will take to pay off all your credit card bill at a nominal 3.25% monthly rate?

Frickin’ 33 months.

And you would have paid Rs. 64,133.20 as interest to the bank along with the original principal of Rs. 1,00,000. You have paid Rs.1,64,113.20 for that TV by not properly using your credit card.

This is of course assuming you haven’t made any extra credit card purchases in that 2.8 years, which is very, very hard. If you add more purchases, your outstanding balance keeps increasing and you would be caught in a never ending debt trap.

This is what many people using credit cards don’t understand and end up losing a lot more than they can earn.

Always remember, the first rule to getting richer is to NOT LOSE MONEY. And misusing your credit cards is a really easy way to lose a significant chunk of your net-worth. In my next article I will be writing about how to get your credit card loans fixed and not lose any more money.

Update: Read the second part of this article – How to repay your Credit Card Debt instantly.

Difference between Service Tax and Service Charge in Restaurant bills

A lot of people don’t understand the difference between Service Charge and Service Tax levied in Restaurants and end up questioning (even fighting) with the restaurant manager. This is becoming more of a problem now that the Government has said that the public doesn’t have to pay Service Charge if they are unhappy about the service.

Restaurant

Lets clear this quite popular and controversial question for all. Let me draw a sample restaurant and bar bill. Lets assume you had some food for Rs.1000 and some cocktails for Rs.1000. Now how much extra are you going to pay and to whom does this money go to?

Restaurant/Bar Bill
Particulars Amount
Food 1000
Alcohol 1000
Sub Total 2000
Service Charge (10% of sub total) 200
Service Tax (5.6% of sub total + service charge) 123.2
Swacch Bharat Cess (0.2% of sub total + service charge) 4.4
Krishi Kalyan cess (0.2% of sub total + service charge) 4.4
VAT (12.5% on food items) 125
VAT (20% on on Alcohol) 200
Total 2657

Service Tax

Service tax is a levy collected by the Central Government for the provision of certain services. The service tax has to be paid by the service provider to the government, and in turn the service providers pass on the amount to the customers.

Taxable services include travel agency, courier services, chartered accountancy, banks, fashion designing, internet cafes, cab rentals, architectural services, telecommunications, and health clubs. Applying service tax on restaurant bills is slightly trickier. If the restaurant has only a non air-conditioned room for its patrons, they don’t have to pay service tax to the government. But if they have a air-conditioned room, they will have to pay service tax to the government even if you didn’t eat in the air-conditioned room. The government wants its money from everyone they can get their hands on.

As of FY 2016-17, the Service Tax component is 14% and it the same across India. Add on a Swach Bharat Cess (money that the government should use build a cleaner India) of 0.5% and a Krishi Kalyan Cess (for improving agriculture and farmer’s welfare) of 0.5%. The total service tax you would have to pay is a round 15%

For restaurants, it is still tricky (they don’t want us to eat in peace, do they?). The government has decided that of the entire amount 60% of it is raw materials of the food/beverage and remaining 40% is the service part. And it makes sense to only levy service tax on the 40% service part, right?

So applying 15% of service tax on 40% of a total comes to another round 6%. Eg: Lets say you eat something for Rs.100. You have to pay 15% service tax on 40% of the Rs.100 = 15% * Rs.40 = Rs.6. This Rs.6 is paid by the restaurant to the government.

Do remember to check for the service tax number at the top of the restaurant bill. If it isn’t mentioned, the restaurant has no business charging it and they might just pocket that money.

Value Added Tax

Value Added Tax or VAT as it is popularly called is levied on any item that are sold in an improved form, meaning some value was added before selling to you. Lot of goods and services are charged VAT at various stages before it reaches the consumer.

In restaurants, VAT is not chargeable on packaged items such as drinking water, bottled alcohol and food. But it is applicable on food and drinks/cocktails prepared in the restaurant kitchens/bar.

VAT is a state tax, so the rate differs from each state and on the type of product. VAT on food items might be different from VAT on alcoholic beverages.

Service Charge

Now coming to the controversial part of the bill. Service Charge is NOT a government charge. It is just another fancy word for Tip. In many countries the waiters and restaurant staff are not paid enough and have to live on the tip they receive from the patrons. It is common to pay anything from 10%-25% of the total bill in those countries.

Now in India since there are no strict working hours, many restaurant staff work for more than 14 hours daily. And naturally they aren’t be paid hourly wages and the salary depends on your experience.

Only a very small percentage of people give tip and the restaurant either had to pay more salary or lose the employee. Some high-end restaurants began charging a mandatory 5% or 10% service charge so that the customers clearly know how much money they are giving to the staff.

Few years back only very few restaurants added a service charge and it was reasonable. People were also happy with the service received to give that service charge. But there are a few restaurants who became greedy and since customers weren’t educated on the difference between service charge vs service tax, began to add more service charge even without providing good service.

So the government had to come in and regulate this saying if the customer felt that the service he received wasn’t satisfactory, he can refuse to pay the service charge.

What will happen in the future?

Now whenever the government tries to regulate any free market, the market will course correct itself. With the new law if more and more customers are going to reject the service charge and also refuse to pay a tip because they are miserly, the restaurant will increase the price of the food item. Instead of being transparent, now the price will be factored into the bill somehow.

People should be reasonable and if they liked the service of the wait staff, they should happily pay a nominal tip. That few hundred rupees you give as tip would make sure that the waiter remembers you and gives you better service the next time around.

Remember this the next time you eat and whenever someone is confused about the charges in a restaurant bill, point them to this article.

Are Sovereign Gold Bond Scheme worth it?

Gold Bars

Last year the Government of India launched a Sovereign Gold Bond (SGB) Scheme, so that a common man will be able to invest in gold without having to buy physical gold and safe guarding in some locker. The investors will get the same returns as physical gold price. In addition to this, you will also get a 2.75% per year interest paid.

Important things to note about SGB:

  • The bond is issued by RBI and any Indian resident can buy these bonds. The minimum one can buy is 1 gram and the maximum is 500 gram.
  • The bond price is linked directly to the price of gold. Whenever Gold price increases, your bond value also increase and vice verse.
  • You need to make sure you have done KYC and transact via bank account. So you can’t convert your cash under the mattress into gold bonds.

Let me answer a few questions people have in their minds about this bond scheme.

1. Physical Gold vs SGB

If you want to invest in Gold purely as investment, the SGB would be ideal. You are guaranteed to receive the current market price of the gold during redemption. It is also safe as you don’t have to store it in your locker. And you don’t have to worry about purity or making charges, etc.
But if you like the touch of the cold, bright, yellow metal and/or buy gold as ornaments (which is an expense and not an investment) this is not for you.

2. But if the price is same as gold what benefits do I get?

The government will pay a fixed interest rate of 2.75% per year of the money invested every year. It is paid every 6 months. You should remember that this interest is taxable at your hand at your tax rates. If you invested Rs. 1 lakh, you will get Rs.1375 every six months. By the way, you should pay taxes on it and show it in your tax returns.

3. Minimum holding period

The bond’s maturity is 8 years after the date of issue. But there are provisions for premature redemption on 5th, 6th or 7th year.

4. Is all my money locked up for 5 years minimum?

Technically yes. But since this is a bond guaranteed by the RBI, this is worth whatever the gold price is on a particular day. So you can go to your bank and use it as collateral for any loans.

5. But I really want my money back today.

You can sell your bonds in the stock exchanges if you hold the bonds in demat format. You can even sell it in multiples of 1 grams. So even if you hold 500 gram of Gold, you can sell 10 gram if thats all you want to. But be warned that the liquidity of these bonds will be very low in the markets.

6. Capital Gains Tax

When you sell your bond, make sure to pay your Capital Gains Tax on the returns (just like you would do on physical gold).

SGB vs Equity?

Now comparing Physical gold vs SGB is easy and it is clear which one is the winner. But comparing Gold vs other investments like equity?

Like I have mentioned before, Equity is the only form of investment that makes your money work actively for you. I agree Gold does have its own bull run, but over a long term view the returns on Gold will be on par with inflation.

8 years is a long enough time period that it wouldn’t be ideal to put all your money in a passive investment like Gold. Of course, people do need to invest a part of their money in gold and for that, SGBs look like a good investment especially with the fixed 2.75% interest you get in addition to the increase due to gold price.