Faced with some tough money management choices amid the COVID-19 outbreak? Read this to sail through this phase with ease.
Tough Choice #1: Should I Continue My Mutual Funds Or Move My Life Savings To The Bank?
The answer depends on whether you prefer lower risk with lower returns, or can bear higher risk for higher returns.
Bank ﬁxed deposits or high-yield savings accounts carry very low risk as no one has lost their deposits with a commercial bank in decades. These currently return 4-6% per annum across diﬀerent large banks for the average saver who is not a senior citizen. However, interest income from ﬁxed deposits is fully taxable as per your marginal slab rate. If your tax slab is 30%, your FD returns will be taxed to that extent, unless you’re a senior citizen eligible for certain income tax beneﬁts on this front. Eﬀectively, for a non-senior citizen, a 6% FD will return 4.2% after income tax and that is your eﬀective post-tax return (refer to Table 2).
If you can bear a little more risk for higher income and lower income tax liability, you can consider liquid mutual funds. Liquid mutual funds invest in high-quality debt and money market securities that mature in 90 days or less and hence considered low-risk. Over the last one year, the liquid fund returns were 5-6%. They had been higher in prior periods, but this answer will consider the last one-year returns. The returns are similar to ﬁxed deposits and high yield savings accounts returns. Liquid funds return approximately 1.3% higher per annum post tax than ﬁxed deposits and high-yielding savings accounts because of their higher tax eﬃciency when held for at least three years (refer to Table 2).
However, all debt-based mutual funds carry a certain degree of risk. Of course, you can make higher returns than in liquid mutual funds by assuming higher risk with ultra-short-term debt mutual fund, short-term debt mutual fund, and other debt mutual funds.
KNOW YOUR LIQUIDATION COSTS & TAX LIABILITIES
Due to the ongoing Covid-19 pandemic, you may be evaluating switching from one instrument to another. For example, you may want to liquidate your debt funds and park the money in bank deposits. In such a situation, be aware of liquidation costs and applicable taxes, and we hope to help you understand this tough choice.
For example, to liquidate your mutual fund units bought in the last 12 months, you might, for example, have to pay an exit load of 1%, for which you need to check your particular scheme documents. Similarly, to prematurely liquidate a bank FD, you may have to take a 1% hit on your interest rate.
While liquidation costs are easy to calculate, your taxes may not be. You must consider the holding period of the asset you’re liquidating to ascertain if it’s a short-term asset or a long-term one. Then, calculate the applicable taxes due to the taxman. You may ﬁnd, for instance, that liquidating your debt mutual fund units held for under three years attract higher taxes than those held for more than three years.
You should take time to calculate basis your particular situation including your asset type and tax bracket. Table 1 shows that if you liquidate your liquid mutual fund investment returning 6% a year in two years and move the post-tax proceeds to an FD returning 6% for one year, you will earn approximately 3.9% less on your capital over the full three years. That means you are earning 1.3% less per annum by switching, in this example from a liquid mutual fund to a ﬁxed deposit even without any exit load. However, with a bank deposit you might get peace of mind about capital protection with lower return, which might be the right choice for you. This is your tough choice to make.
Table 1: Liquid Mutual Fund With 6% Returns Over 3 Years *
|2014||INR 100,000||INR 6,000|
|2015||INR 106,000||INR 6,360|
|2016||INR 112,360||INR 6,742|
|2017||Liquidation Value||INR 119,102|
|Asset Classiﬁcation||Long Term **|
|CII Values for 2014 and 2017||240 & 272|
|Indexed Purchase Value of Asset||INR 113,333|
|Long Term Capital Gains||INR 5,768|
|Tax On Gains @20.60%||INR 1,188|
|Actual Gains||INR 17,914|
|Post-Tax 3-Year LM Investment||INR 117,914|
If Liquid Mutual Fund Liquidated In 2 Years
|2014||INR 100,000||INR 6,000|
|2015||INR 106,000||INR 6,360|
|2016||Liquidation Value||INR 112,360|
|Asset Classiﬁcation||Short Term **|
|Short Term Capital Gains||INR 12,360|
|Tax On Gains At Slab Rate Of 30%||INR 3,708|
|Post-Tax 2-Year LM Investment||INR 108,652|
Liquid Mutual Fund Proceeds Reinvested In 6% FD For 1 Year
|Principal Invested||INR 108,652|
|6% Interest||INR 6,519|
|30% Tax On Interest||INR 1,956|
|Post-Tax Interest||INR 4,563|
|FD Value After 1 Year||INR 113,215|
|Value Of 3-Year Liquid MF Investment||INR 117,914|
|Loss Due To Shift From Liquid MF To FD||INR 4,698|
|Loss As %age Of 3-Year LM Investment in 3 year||3.98%|
* Liquid mutual fund returns are never guaranteed; 6% is used for illustrative purposes only. ** Debt mutual fund units held for three years or longer become long-term assets; those that aren’t remain short-term assets.
WITH EQUITY, THINK LONG TERM
However, with a higher risk appetite and a long-term horizon, you could retain or shift your savings to equity index mutual fund investments. If you’re prepared to wait for ﬁve years from now, you can invest in equity index mutual funds because over the long-term, these have always outperformed post-tax returns from ﬁxed deposits. The key is time.
If you need money in a year or two, you should not be invested in equity mutual funds to start with and should immediately move to a liquid mutual fund or a bank ﬁxed deposit or high yield savings account to protect your life savings and minimize risk. However, if your investment horizon is longer than ﬁve years, you might be better oﬀ in an index mutual funds versus a ﬁxed deposit. As always you should ponder and make the right choice basis your circumstances.
Tough Choice #2: Choosing Between Continuing My SIP Or Paying My Loan EMIs During Moratorium?
Answer: This is straightforward. If your income is strained to a level where you have to pick between paying your EMIs and continuing your SIPs, pay your EMIs. Even though you have the option of delaying your EMIs with the RBI-mandated moratorium of six months, you should prioritize paying your EMI dues.
INVESTING IS OPTIONAL BUT EMI IS AN OBLIGATION
Investments, while critical to your long-term wealth-creation eﬀorts, often tend to be optional. They can be paused or cancelled. On the other hand, repaying your loan is an obligation that must be mandatorily met.
ONE MISSED EMI MEANS PAYING SEVERAL MORE EMIS
You should avoid using the moratorium while you have the income to pay your EMIs. This is because even one missed EMIs could potentially lead to several more EMIs during the tenure of your loan. For example, if you deferred the ﬁrst ﬁve EMIs of a 20-year home loan, you’ll end up paying 30 more EMIs. Hence, using the moratorium while you can pay your EMIs, is a costly option. This is detailed in Table 3.
YOU CAN PAUSE SIPS IN ORDER TO PAY YOUR LOAN EMI
Remember that you only need to pause your SIPs which does not require you to liquidate your mutual fund units. Once you have income stability, resume investing again. Hence this is straight forward, if your income is strained to a level where you have to pick between your paying your EMIs even during moratorium or continuing your SIPs, pay your EMIs.
SHOULD YOU LIQUIDATE SAVINGS TO PAY EMIS, EVEN DURING MORATORIUM?
This is a tough choice and the answer might be yes. Consider that the lowest risk instrument for a retail customer is a bank ﬁxed deposit or high-yield savings accounts, followed by a liquid mutual fund. The category returns for one-year (forward-looking) ﬁxed deposits today are 4-6% depending on which large bank you choose, and the one-year (backward-looking) liquid mutual funds returns are also 5-6%. Hence, your post-tax returns on low-risk instruments are 4.20% on the ﬁxed deposit and 5.64% on the liquid mutual fund in the example in Table 2. However, your interest rate on your home loan is closer to 8% per annum and your personal loan is 10%+ and credit card debt is 30%+.
Now consider the liquidation cost of breaking your investments and, as always, calculate this basis your speciﬁc circumstance. But for this example, let’s assume you are breaking a ﬁxed deposit and thereby paying a -1% penalty on the breakage which is an eﬀective loss of principle. Despite the liquidation cost, you may be better oﬀ liquidating that deposit earning 4.2% and additionally incurring -1% penalty, and paying oﬀ your home loan accumulating interest at 8%. Therefore, it may be in your long-term interest to liquidate your savings to pay your EMIs, even during the moratorium.
Table 2: Post-Tax Returns On Fixed Deposit & Liquid Fund Over 3 Years
|6% FD Over 3 Years||Liquid Funds With 6% Returns Over 3 Years*|
|Taxes Paid (@30%)||Actual Return||
|2014||INR 100,000||INR 6,000||INR 1,800||INR 4,200||2014||INR 100,000||INR 6,000|
|2015||INR 104,200||INR 6,252||INR 1,876||INR 4,376||2015||INR 106,000||INR 6,360|
|2016||INR 108,576||INR 6,515||INR 1,954||INR 4,560||2016||INR 112,360||INR 6,742|
|2017||Maturity Amount||INR 113,137||2017||Liquidation Value||INR 119,102|
|Total Taxes Paid||INR 5,630||Asset Classiﬁcation||Long Term**|
|Total Post-Tax Interest Earned||INR 13,137||CII Values for 2014 and 2017||240 & 272|
|What You Gained:||FD||LF||Indexed Purchase Value of Asset||INR 113,333|
|Invested||INR 100,000||INR 100,000||Long Term Capital Gains||INR 5,768|
|Gains||INR 13,137||INR 17,914||Tax On LTCG @20.60% ***||INR 1,188|
|Taxes||INR 5,630||INR 1,188||Actual Gains||INR 17,914|
|Effectual Post Tax Interest Rate
* – assumed returns. ** – debt mutual fund with holding period of 3+ years is a long-term asset. *** LTCG from debt funds taxed at 20.60% with indexation beneﬁts
Tough Choice #3: If I Have To Choose Between Paying An Insurance Premium Or Paying My Loan EMIs During The Moratorium Period?
Although both loan repayments and insurance premiums are extremely important ﬁnancial commitments in their own ways, if you were to choose between the two, assuming you’re going through a cash crunch and for the period of the moratorium, you should prioritise insurance premium payments after carefully considering the ﬁnancial implications of opting for a loan moratorium.
The Covid-19 crisis has tremendously heightened various uncertainties. Adequate life and health insurance coverage is one of the few eﬀective ways to safeguard one’s family’s ﬁnances against adverse possibilities such as hospitalisation or death. Your insurance plans lapsing would put your family’s ﬁnances at great risk. The Reserve Bank of India has recently extended loan moratoriums for three more months ending August 31, 2020.
BOUNCE BACK FROM THE ADDITIONAL DEBT
After taking the moratorium, you’re going to accumulate additional interest which makes it more challenging for you to repay your loan. For example, on a loan of Rs. 50 lakh at an interest rate of 8.50% and a tenure of 20 years, your EMI is Rs. 43,391. Assume you had to defer your ﬁrst ﬁve EMIs through the moratorium. This will increase your projected interest from Rs. 54.13 lakh to Rs. 64.82 lakh, and also increase your loan tenure from 240 months to 270 months. Therefore, it is in your interest to proactively reduce the additional debt you’ve created. The way to do this would be to pre-pay a little more than the amount you had to defer. In the above example, if you had deferred ﬁve EMIs totalling Rs. 2.17 lakh, you could simply pre-pay 120% of this amount within 12 months of the last deferred EMI. This would erase the additional debt.
Loan of Rs. 50 lakh at 8.50% for 20 years
EMIs: 240 Total Interest: INR 5,413,879 EMI: INR 43,391
|If You Take the Moratorium From April To August||Your Bounce-Back Plan|
5 Deferred EMIs
Interest For Deferred EMIs
Option 1: Loan Extension In Months, Same EMI
|Option 2: Increase In EMIs,
|Pre-Pay Your 5 Deferred EMIs (Rs. 216,955)
12 Months After Last Deferred EMI
With EMI #
|1 to 5||INR 176,514||270||INR 6,482,370||INR 1,068,491||INR 45,316||INR 1,925||18||243||INR 5,531,614||INR 950,756|
|13 to 17||INR 172,939||267||INR 6,367,314||INR 953,435||INR 45,357||INR 1,966||30||243||INR 5,521,974||INR 845,339|
|61 to 65||INR 158,285||259||INR 6,007,587||INR 593,708||INR 45,589||INR 2,198||78||242||INR 5,490,717||INR 516,870|
|121 to 125||INR 122,620||252||INR 5,715,451||INR 301,572||INR 46,195||INR 2,804||138||242||INR 5,464,082||INR 251,369|
|181 to 185||INR 75,973||248||INR 5,531,471||INR 117,592||INR 48,236||INR 4,845||198||241||INR 5,446,718||INR 84,753|
Disclaimer: The illustrations and advice are for ﬁnancial education only. The ﬁgures used in the tables are illustrative and liable to periodic changes. Income tax rates depend on one’s income, sources of income, capital gains, and age. The examples used in this document may not apply to your situation. When in doubt, take control of your ﬁnances and calculate for yourself or consult a qualiﬁed tax or investment advisor if need be.
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