How to earn higher returns than FDs?

Financial experts are known to repeat the axiom that death and taxes are inevitable in life. But they forget to add one more item to the list: contingency funds. Due to the uncertainties that govern our life, we don’t have an option but to maintain a corpus to meet emergencies. The golden rule, most wizards maintain, is to maintain emergency funds to match at least four months’ expenses.

Such money in most cases is kept in savings accounts or invested in liquid funds or fixed deposits of very short term, say 30-91 days. The idea here is to earn some returns without compromising liquidity.

What are bond funds?:

Short-term bond funds and ultra short-term funds (also known as liquid-plus funds) have emerged as preferred vehicles for investors to ride out rising interest rates. Short-term bond funds are mutual fund schemes that invest in bonds and other fixed-income instruments that have a tenure of around one year. The fund manager builds a diversified portfolio of fixed-income instruments with varying maturities. The portfolio comprises treasury bills, certificate of deposits, commercial papers, securitised debt and advances in the call money market.

The ultra short-term fund focuses on very short-term instruments in the fixed-income space. It invests most of the money in call money and other shortterm instruments, offering good liquidity (for a listing of these funds see table). The Reserve Bank of India (RBI) has increased the repo rate (the rate at which it lends to commercial banks) by 125 basis points in this financial year. This, in turn, pushes up the rate of interest on shortterm borrowings for corporate entities and commercial banks.

What do they do with your money?

These funds invest in financial securities that mature in three months which are currently offering an annualised return of 9%. They also invest in one-year tenure instruments that offer 9.25% returns . Of course, public sector banks have also been hiking interest rates on their fixed deposits. But the returns offered by short-term financial securities are higher than fixed deposits offered by large banks for a similar tenure, which makes the fund route rather attractive.

Let’s take the case of one-year fixed deposit . The interest rate being offered currently by most banks is in the range of 7.5-8 .5% whereas short-term financial securities offer higher returns. Shortterm funds invest in short-term financial securities. So in the days to come it is highly likely that that these funds may give higher returns than those given by fixed deposits.

Why should you invest?:

Also, once an investor invests in a fixed deposit he is locked into it. If the interest rate keeps rising, it will be difficult for him to capture the higher interest rate unless he breaks the current fixed deposit to get into a new fixed deposit. That, of course, has its own issues. But, if the investor invests in ultra short-term funds and short term bonds, he can hope to capture the higher interest rates that may be on offer. These funds invest in different kinds of financial securities which have varying maturity periods.

So, the money coming in from the financial securities that mature can be used to invest in the new financial securities offering a higher rate of interest.

In the recent monetary policy, RBI has left the key rates unaltered. Though the statutory liquidity ratio (SLR) has been reduced to 24% from 25% to accommodate liquidity along with bond buy back, there is no signal from RBI regarding lowering of short-term interest rates. The regulator has not taken any long-term measure to improve liquidity which may bring down the short-term rates.

This is also the season when companies pay advance tax to the government. This means all the idle money that companies have is going to disappear. This, in turn, would mean a further scarcity of money in the market, which would push up interest rates further.

Over and above this, till the end of this financial year — March 31, 2010 — there is a strong line of initial public offerings (IPOs) and follow-on public offerings (FPOs) that are expected to hit the stock market. This will further tighten the money situation, creating more demand than supply, and hence higher interest rates.

Also, to support the increased lending, banks will issue more certificates of deposits on higher interest rates. All these reasons make an even more strong case for investing in short-term and ultra short-term funds.

It makes sense to look at exit loads if any, especially in case of short term bond funds before investing. Funds with low expense ratio spell out better returns.

What about tax?:

An investor looking to invest in these funds with a less than oneyear time-frame in mind should ideally go for the dividend option to ensure better post-tax returns. The dividends declared by liquid-plus and short-term bond funds attract tax at 13.841%. If you opt for the growth option, your gains will be treated as short-term capital gains and taxed according to the income tax bracket you fall into.

So, if you fall in the top tax bracket, you will be taxed at the rate of 30.9%. Mutual funds typically keep declaring dividends on these schemes so as to ensure that investors’ gains are taxed at a lower rate of 13.841%, making the monthly dividend option more attractive for short-term investors.

Also, if you want to invest for a period that exceeds one year, and you happen to choose the growth option, your gains will be taxed at the rate of 10% without indexation or 20% with indexation, which ever is higher. If you invest in a fixed deposit and fall in the top tax bracket, the interest earned will be taxed at 30.9%.

What are the risks?:

But a point to note is that interest rates and prices of financial securities move in opposite directions. So, if interest rates keep going up, the prices of financial securities go down. This is because the newer financial securities offer a higher rate of interest. This, in turn, means that the net asset value of the scheme also goes down, leading to lower returns.

So, it is essential to enter these funds at the right time and stay invested throughout the up-cycle . In case of short-term bond funds, once you get your timing of investment right you should stay invested for at least a year’s time to ride out the investment cycle as well as ensure that your capital gains are taxed at lower tax rates.

Four financial thumb rules you can follow

Here are some time-tested financial thumb rules pertaining to borrowing and investing in fixed deposits

They say when your values are clear to you, making decisions becomes easier. The maxim also works when it comes to making financial decisions. Here are some time-tested financial thumb rules pertaining to borrowing and investing in fixed deposits. However, there are several other thumb rules for various financial decisions.

While borrowing, monthly rest is better than quarterly and quarterly is better than annual.

When you take a loan, the most important parameter to look into is the rate of interest. Then there are fees such as processing and pre-payment charges, loan tenor and the like. Let’s assume that you have an option to borrow from two different lenders and all the parameters are the same. How would you choose then?

The word “rest” is used in the milieu of a reducing balance loan. Rest describes the periodicity at which the principal amount is reduced as you repay the loan. Rests are usually monthly, quarterly and annual.

How it works:A monthly rest takes into account the reduced principal after each equated monthly instalment (EMI) and accordingly applies the interest rate on the reduced principal. If the rest is quarterly, the repaid principal amount is adjusted every quarter and so on.

It’s always best to go for monthly rest, loans with annual rest become expensive. For instance, if you borrow Rs. 5 lakh at 12% for 20 years, the total interest you pay on a monthly rest clause is Rs. 8.21 lakh. You pay Rs. 8.24 lakh on quarterly rest and Rs. 8.38 lakh on annual rest.

Not more than 30-35% of your income.

An average urban family today has two to three loans—such as loans for home, car and consumer durables—going at a given point of time. But while taking loans has become easier, repaying them could become a problem and you may not even realize when you slip in a debt trap.

So ensure your borrowing should never exceed 30-35% of your income. This means that if you earn Rs. 100 per month, your EMIs should not exceed Rs. 30-35 a month.

About 30% of monthly income as EMIs for all debt is ideal. Anything more than that could cause trouble. For instance, if the EMI on your home loan goes up due to rise in interest rates, there is a good chance of you getting trapped. If more than 45% of your income goes to service debt you are already heading into a debt trap.

Remember the ratio 20:4:10 when taking a car loan.

Most people buy a car on loan and this ratio would be useful in making a decision. In this ratio, 20 (or more) stands for down payment, ensuring that you have paid a substantial amount initially, which will decrease the overall cost of your loan.

Then, 4 stands for the tenor. While banks may offer you a car loan for up to seven years, it’s best to stick to a four-year tenor or less. Says Ranjit Dani, a Nagpur-based certified financial planner, “The longer the tenor of the loan, the higher is the total cost of the loan; the sooner you get rid of the loan, the better the deal.” That way not only does the total cost of the car goes down, you also get to own it sooner.

The last figure in the ratio, 10, stands for the percentage of your monthly income you should shell out for your car EMI. In other words, your car EMI should not exceed 10% of your monthly income.

Higher the compounding, more the amount of future value.

When you make an investment, the instrument quotes the nominal rate of interest. But that may not necessarily be the rate of interest which you would actually earn. Your earning depends on the type of compounding applied, so your effective rate is the annual rate of interest that accounts for the effect of compounding. A rate can compound monthly, quarterly, semi-annually or annually.

Let’s assume you invest Rs. 50,000 at 12% for a year. If the instrument compounds the interest on a monthly basis, your Rs. 50,000 will grow to Rs. 56,341.25; if the instrument is compounded quarterly, you will get Rs. 56,275.44; with semi-annual compounding, you will get Rs. 56,180; and with annual compounding, you will get Rs. 56,000. This clearly shows that the shorter the compounding frequency, higher would be the future value of your investment. In monthly compounding, you earn interest on interest compared with annual compounding. Higher the compounding, more is the incremental amount you earn.

Keep in mind that interest of fixed deposits can be compounded quarterly, half-yearly or annually and varies from bank to bank.

Following these general thumb rules will help you make informed decisions.

Small savings committee proposes to restructure agent commission

The report by finance ministry’s committee on small savings recommends either reducing or completely abolishing the commission paid to agents on various small savings schemes

The finance ministry’s committee on small savings chaired by Shyamala Gopinath, deputy governor, RBI, has recommended either reducing or completely abolishing the commission paid in the Standardised Agency System (SAS), Mahila Pradhan Kshetria Bachat Yojana (MPKBY) and Public Provident Fund Agents (PPFA). These recommendations were made in the report “The Committee on Comprehensive Review of National Small Savings Fund (NSSF)”.

The committee recommends that under PPF, the commission should be abolished, as 90% of the transactions are happening through banks and for banks commission is not payable for any other scheme. They feel that 4% commission under MPKBY is very high and is affecting the viability of NSSF.

The committee recognizes that the recurring deposit (RD) scheme requires considerable effort on part of agents in mobilizing monthly deposits. But calling the 4% commission distortionary and expensive, the committee recommends bringing down the commission to 1% in a phased manner in a period of three years with a 1% reduction every year.

In addition, under SAS, the committee recommends that commission of 0.5% should be abolished on Senior Citizen Saving Scheme whereas on other schemes, it should be brought down to 0.5% from 1%.

According to the report the 13th Finance Commission (FC) noted that, “Incentives such as cash awards to officials and other similar measures to promote subscription to small savings instruments either add to the cost of administration or affect normal market linked subscription. Hence, such incentives should be proactively withdrawn by the state government.”

Agreeing with 13th FC, the committee noted that agency charges distorts the investment pattern and increases the effective cost of borrowings for NSSF. Thus, in order to ensure that the state governments do not give any extra incentive to the agents, the committee has recommended that the incentive paid to the state government may be reduced from the incentive payable by the central government to the agents.

7 Most Common Myths About Fixed Deposits

Rising interest rates and volatile stock markets, it’s that time when banks and financial institutions are aggressively marketing the safe investment option – “Fixed Deposits”. However, very often we see that various misconceptions about Fixed Deposits prevail among investors. Here’s making you aware about some of the most common “Myths and Facts” that you may face while investing in one.

Myth 1: Only Banks Offer Fixed Deposits.

Fact 1: Fixed Deposits Are Offered By Companies Too.

If you thought you could only approach your bank to invest in a fixed deposit, well that’s not so. Various companies and financial institutions too offer fixed deposits for retail investors. Companies offering deposits are governed by proper guidelines under section 58A of the companies act. They generally offer a little higher interest rate than bank deposits.

However, when compared to bank deposits, company fixed deposits are considered as an unsecured option. This is because bank deposits come with insurance for up to a maximum of Rs. 1,00,000.

Myth 2: More Number Of Regular Interest Payments, More The Returns.

Fact 2: A Cumulative FD With Returns Only On Maturity Would Fetch You More.

Fixed deposits come with two options; of receiving interest payouts at regular intervals, or a cumulative deposit, where the whole amount (i.e. principal + interest) is received on maturity. Your annualised yield on your FD works out to be higher if you opt to receive the proceeds on maturity. This is due to the power of compounding. In cumulative deposits, the interest is compounded at regular frequencies, instead of it being paid out. Higher the frequency of compounding more is your yield on investment.

Myth 3: All 5 Year Deposits Fetch You A Tax Benefit.

Fact 3: Only Select 5 Year Fixed Deposits Fetch You a Tax Benefit.

Under Section 80C, investments in select fixed deposits of 5 year tenure, provide an exemption of up to Rs. 1 lakh. Such fixed deposits, must be essentially from a bank, and are locked for the tenure, during which time, they can not be pledged nor withdrawn. Also the fixed deposit certificate must mention the tax benefit under section 80C, on the face of the certificate.

  

Myth 4: TDS on FD Cannot Be Avoided, As It Has To Be Paid By All.

Fact 4: Providing Necessary Documents Could Help Avoid TDS.

Tax Deducted at Source on a fixed deposit is deducted once interest, in one single financial year, exceeds Rs. 10,000 for bank deposits and Rs. 5,000 for company deposits. Housewives, minors or senior citizens, who do not have any other source of income, or whose income is below the taxable limit, could avoid this TDS. All that needs to be done is to provide the bank, Form 15G, or Form 15H in case of senior citizens, well in advance in the financial year.

  

Myth 5: FD Interest Earned Need Not Be Declared In Your Tax Returns.

Fact 5: Income Earned on FD Should Be Included In Annual Tax Returns.

Well, if you are earning an income from your fixed deposits, you need to declare the same. Interest Earned from your FD must be included in your annual tax returns under the head “Income from other sources”.

Myth 6: Pre Mature Withdrawal Is The Only Way, If I Need Money Mid Way.

Fact 6: FD’s Have Other Options In Times Of Contingencies.

If at any time you require money from your FD, most banks offer part withdrawal of funds, so that you could withdraw the actual amount you require, and the balance would continue to earn interest. Some banks also offer flexi deposits, were the deposits are linked to a savings account. All excess amounts in the saving account are automatically swept into a deposit. If one requires money at any time, he could withdraw just as he would from a savings account. Automatically parts of the deposit are broken to cater to the withdrawal. Also, overdraft facilities are available of up to 80 to 90% of the FD amount. Please note: Tax saving FD’s do not have these options.

  

Myth 7: In the Long Term, Fixed Deposit Offers Better Returns Than The Stock Market.

Fact 7: The Effective Returns From an FD Are Lower Than Stock Market Returns

This is due to the fact that fixed deposits are unable to beat inflation. For example, if the deposit earns you 9% p.a. and the inflation is at 8%, the inflation adjusted returns works out to only 1% (9-8). A stock market portfolio may probably give you a much higher effective inflation adjusted returns in the longer run.