Saturday, December 17, 2005

The Seven you know before taking Insurance

What you should know

1. If you have absolutely no dependent family (parents, spouse, children), then there is no need to opt for this policy. But, if you do have a family or dependents, term insurance is a must. No other policy will offer you as much value for money as this one.

2. Do not think of it as an investment. Look at it purely as an insurance tool and a safety net for your family. Should something happen to you, your family (wife, children or parents) will get a fair amount of money in hand.

3. If you opt for other forms of insurance where you are assured of your money being returned to you, the premium is much higher. And, to avoid paying such a high premium, there is the risk that you may opt for a lower cover and hence be underinsured.

4. Term insurance should be bought at a young age. The older you get, the higher the premium. The trick is to buy it at a young age for a lesser premium and for the maximum possible tenure.

5. You can opt for a single-premium term policy or a regular premium term policy. The former would definitely be more convenient but the latter would be a better option. The financial load is much less when paying a regular premium every year rather than a huge lumpsum at one go.

6. You can even opt for riders on your policy. These are optional add-ons which can be attached to the main insurance policy for an additional premium.

This additional premium is added to the main premium and has to be paid along with it.

For instance, a double accident benefit rider means that if you die in an accident, your family gets double the sum assured in your main policy. So if your cover is Rs 20 lakh (Rs 2 million), they get Rs 40 lakh (Rs 4 milion). Or, a critical illness benefit rider will cover specified illnesses like cancer or a heart attack. There is also a disability benefit rider where you get a specified income till the end of your policy should you become permanently disabled.

7. Premiums will vary between companies. So do take a look at a few before you make up your mind. But, don't make the lowest premium your sole criteria. Also, look at the features of the policy.

The good and bad about term insurance

Term insurance is the purest and simplest form of life insurance.

You pay the company a premium for a certain number of years. Should you die during this time, the beneficiary gets the money.

Should you live, which is very good, you will lose all the premiums paid. And, you get no money at all.

Let's say you take a policy for 30 years. If you are fortunate and outlive your policy -- which, we're sure, you would really love to do -- the investment will turn out to be quite worthless and you will lose all the money you paid.

If you do not outlive your policy (which would be a tragedy), the people you nominate in it will get the money.

In the first scenario, you pay; you get nothing; your beneficiary gets nothing.

In the second scenario, you pay; you get nothing; your beneficiary does.

Either way, you personally do not benefit.

That's the bad part about term insurance.

The good part about term insurance is that it is the cheapest life insurance available, so you pay the least amount of premiums.

Insurance for your 20s!

nsurance is a vague game.

You assume that tragedy is going to hit (though you don't want it to) and so you pay the insurance company an amount. In return, they promise to help you out financially if your nightmare does come to pass, which you sincerely hope and pray doesn't.

Ironically, if the tragedy does occur, you (or your family) gain from the policy. If it does not, you lose. And the entire policy turns out to be a waste of hard-earned money.

Yet it is a must. But, where you can be smart is by picking the right insurance cover.

If you are in your twenties, either single or newly married, then a term insurance policy is your best bet.

ImageHow it works

What you are expected to do

All you have to do a pay a premium.

Premium refers to the amount you will have to pay the insurance company. This could be a one-time payment or a periodic, annual payment.

What the insurance company is expected to do

The company will cover you for the amount you are insured.

So, if you have taken a term insurance policy for Rs 10,00,000, then should you die, this is what the insurance company has to pay up.

Who benefits?

The beneficiary. This refers to the person/ s you have named in the policy; they are the ones who will get your insurance money.

The tax on withdrawal

The tax on withdrawal

When you look at the taxability of a certain investment, there are three aspects to consider:

1) Tax when you make the investment

2) Tax on the income you earn from such an investment

3) Tax on the maturity of the investment

For example, if you invest in a pension fund, the annuity (amount the insurance company pays you regularly as an income) may be taxable. But, your returns in a PPF are not.

This obviously creates a bias in the minds of the investors against the taxable investment option.

In order to remove this bias, the tax department has proposed to move towards EET (Exempt, Exempt, Taxed) basis of taxation through the three stages mentioned above.

According to this method of taxation, all investments would be taxable on receipt/ withdrawal/ maturity from such investment.

Hence, all investments are now in one basket - Section 80C - in order to facilitate this EET based taxation.

If the EET basis of taxation is made applicable, then the investment would become taxable at the time of receipt/withdrawal.

That means that your PPF too would be taxable. Most probably only amounts from this year onwards.

The amount saved with section80c

The limit

The limit under this section is Rs 100,000.

This is irrespective of how much you are earn and under which tax bracket you fall.

Also, there are no sub-limits under this overall Rs 100,000 amount.

So if you choose, you can invest the entire amount in ELSS or infrastructure bonds. The choice is entire up to you as to how you want to reach this limit.

Or, if you are repaying a home loan and the principal repayment amounts to Rs 100,000, then you can claim the entire amount as a deduction.

Earlier, the principal repayment of home loan was restricted to only Rs 20,000, irrespective of how much you actually paid. Not so any longer.

The investments that fall under Section 80C

The investments that fall under Section 80C.
  • Provident Fund
  • Public Provident Fund
  • Life insurance premium
  • Pension plans
  • Equity Linked Saving Schemes of mutual funds
  • Infrastructure bonds
  • National Savings Certificate

Besides these investments, the payments towards the principal amount of your home loan are also eligible for an income deduction.

All the above must be made from the current year's earnings and not past earnings. So if you are paying tax for the financial year 2005–'06, then your investments must be made from earnings during this period.

The tax benefit with ELSS

Investments in ELSSs fall under Section 80C.

The limit under this section is Rs 100,000.

This is irrespective of how much you earn and under which tax bracket you fall.

Also, there are no sub-limits under this overall Rs 100,000 amount.

So, if you choose, you can invest the entire amount in ELSS or infrastructure bonds. How you utilise the limit of Rs 100,000 is entirely up to you.

The dividends you earn in an ELSS are tax free.

When you sell the units of these funds, you can benefit from long-term capital gain, under which you don't have to pay capital gains tax.

What you MUST know before taking a loan

What loan tenure should I opt for?" This question was posed to us by a reader recently.

Since the loan tenure is directly related to the Equated Monthly Installment, let's look at this concept first.

After you take a loan, you will have to repay part of it every single month. This is irrespective of whether it is a vehicle loan, home loan, personal loan or education loan. Repayment is always done on a monthly basis.

This amount that you repay every month is referred to as the Equated Monthly Installment.

The EMI stays constant

There are two parts to loan repayment -- the principal amount and the interest payment.

Interestingly, the EMI, which is generally a fixed amount, is an unequal combination of interest repayment and principal repayment.

Sure, there are exceptions. You could also ask for an EMI that changes over the years such as an ascending EMI or descending EMI (which means your EMI increases or reduces over the years).

Let's work it out with a constant EMI.

Loan amount: Rs 1,00,000
Rate of interest: 8.75% per annum
Tenure: 10 calendar years
EMI: Rs 1,254

Let's say that the EMI payments start from January 1, 2006.

So while the EMI remained constant every month, at the start of repayment, you were paying a higher component of interest and towards the end, a higher component of principal.

The EMI is affected by tenure

The EMI may be constant but what you need to look out for is the tenure. Let's work it out with some figures.

Interest rate = 9% per annum
Loan amount = Rs 10,00,000
Tenure = 5 years / 60 months
EMI = Rs 21,424
Total amount you will pay over the 5 years = Rs 12,85,440

Interest rate = 9% per annum
Loan amount = Rs 10,00,000
Tenure = 8 years / 96 months
EMI = Rs 15,056
Total amount you will pay over the 8 years = Rs 14,45,376

Interest rate = 9% per annum
Loan amount = Rs 10,00,000
Tenure = 3 years / 36 months
EMI = Rs 32,921
Total amount you will pay over the 3 years = Rs 11,85,156

The lesser the tenure, the higher the EMI.

The lesser the tenure, the less you eventually pay to the financier.

Does that mean you should take a short tenure loan and a higher EMI?

Broadly speaking, yes. However, you will have to look at a number of factors before you reach that decision.

1. Tax benefits

If you are getting tax benefits, as you would on a home loan or education loan, then you may want to service the loan for a few years. If you are getting no tax benefits, you should look at repaying it quickly.

2. Comfort level

You may want to pay back the loan as soon as possible, but you may not be able to afford a higher EMI. In this is the case, you may have to opt for a loan with a longer tenure so you will have more time to pay it off.

3. Salary increases

If you are in a job where you foresee high increments every year, you can opt for a shorter tenure. Let's say you are paying back Rs 10,000 a month and you are earning Rs 30,000 a month. Let's further assume you are going to get a hike to Rs 38,000 per month.

Now the EMI stays constant but you are earning much more so it does not pinch as much. Opting for a shorter tenure and a high EMI makes sense if you foresee rapid or substantial increments.

4. Interest rate

If the loan has a high interest rate, it is best to pay it back as soon as possible. On your home loan, you would have got a very competitive rate. But you will be paying a high rate of interest on your personal loan. In such instances, even if it means living on tight budget, opt for a higher EMI.

Finally, you will have to work out a deal you are comfortable with. For instance, let's say your friend has taken a loan and is servicing an EMI of Rs 4,500. You may want to take the same deal.

If he is earning Rs 15,000, the EMI would be 30% of his income. But, if you are earning Rs 30,000 per month, the EMI would be just 15% of your income. Maybe you could take a higher EMI if you can afford it.

So don't go by absolute figures, see what percentage of your earnings is going towards loan repayments. Only then take a call.

Bank deposits versus post office savings

Everyone says interest rates are rising. This is true even for deposit rates. So does that mean bank deposits could now be a better option to post office savings?

Here is a bird's eye view of recurring and fixed deposits offered by banks and post-office.

Post office Recurring Deposits VS Bank Recurring Deposits

A post office recurring deposit account (RDA) is similar to a recurring deposit in a bank, where you can invest a fixed amount on a monthly basis. The postal RDA has a fixed tenure of five years.

These deposits accumulate money at an annual fixed rate of interest of 8 per cent. The interest is compounded on a quarterly basis. The minimum investment in a post office RDA is Rs 10 and there is no prescribed upper limit. For example, if you invest Rs 100 every month in 60 instalments, you will earn a sum of Rs 7,289 after 5 years.

Banks, however, offer a flexible time period on their recurring deposits. You can open an RDA for a minimum period of 6 months, and thereafter in multiples of 3 months up to a maximum period of 10 years.

In banks, you can start a recurring deposit with State Bank of India for a monthly instalment of Rs 100 whereas ICICI Bank has kept its minimum deposit limit at Rs 500.

An individual can open an RDA account with a post office individually or one in a joint form with another investor, or a guardian on behalf of the minor who has attained the age of 10 years can open an RDA account in his/her own name.

The advantage with post-office deposits is that it offers a fixed rate of return for the duration of the deposit, while banks constantly review their recurring deposit rates.

However, the disadvantage with post office savings is that that in the age of convenience banking, you will have to visit the post office every month. In case of banks, the amount is automatically debited from your account. Premature withdrawal, however, cannot earn you desired returns.

In post office RDA, you can withdraw up to half the balance. On premature closure of the account (after one year), interest is payable as per the rate for the Post Office Savings Bank Account, which is 3.5 per cent.

In the case of banks, premature closure of an RDA will attract a penal interest. This means the depositor will get interest around 1 per cent less than the prevailing rate. It will certainly be higher than the 3.5 per cent paid by post office.

Post office Time deposits vs Banks' Fixed Deposits

Just like banks' fixed deposits (FDs), post office time deposits are meant for those investors who want to deposit a lump sum for a fixed period.

Time Deposits are of 1 year, 2 year, 3 year and 5 year tenures. The minimum investment should be Rs 200 and its multiples. The tenure of bank fixed deposits are flexible, with periods ranging from 15 days to 10 years but the minimum amount is as high as Rs 10,000.

In case of postal time deposits, the account can be closed after 6 months but before one year of opening the account. On such closure, the amount invested is returned without interest. If a time deposit of two or three years is withdrawn prematurely, post office will pay interest only for the completed year or years.

For example, a fixed deposit for two years is withdrawn after 20 months, interest will be paid only for the one full year completed. The depositor will lose interest for the remaining 8 months.

If a bank FD is closed before completing the original term of the deposit, banks have the discretion to charge penal interest. If a bank decides to charge penal interest, the depositor will be paid interest at a lower rate than that was contracted.

A postal time deposit fetches annual interest rates in the range of 6.25 to 7.5 per cent. A bank FD offers annual interest rates in the range of 3.75 per cent to 7.27 per cent. Senior citizens enjoy the privilege of earning higher interest rates on bank FDs, ranging from 4.25 per cent and 7.95 per cent.

In the post-office scheme your investment grows at a pre-determined rate with no risk as it is backed by the government.

Why PF rates must drop

If you belong to the four crore (40 million) employees who have their savings in the Employees Provident Fund, you must have been pained to hear that the government is about to reduce the rate of interest on the EPF to 8.5% from the 9.5% it used to pay earlier.

Is it justified?

The finance ministry, which has been campaigning for bringing the rate down to 8.25%, points out that no other fixed deposit or small savings scheme offers a return of 9.5%.

In fact, the actual rate of return on the EPF is much higher, because the savings under the scheme are eligible for tax deduction under Section 80C and there is no tax on the interest earned. So the effective rate of return on the EPF is much more.

Also, the 10-year central government bond has a yield to maturity (return you get if you hold the bond till maturity and do not sell it before the tenure ends) of around 7.1% and the 17-year bond earns a return of 7.5%.

Hence, taking into account that the EPF is illiquid (you cannot take out the money whenever you want), 8.5% seems to be a reasonable rate.

You must understand that the money in EPF can only be invested in notified securities like government bonds, with a small proportion in corporate bonds. Given the low interest rates, obviously it can't pay much.

Further, the corpus is managed by government employees and not professional fund managers.

Interestingly, the world's largest pension fund, CALPERS, the pension fund for employees in California, is investing in the Indian stock market. And, pension funds in the US and Europe regularly invest in stocks.

If the EPF too is allowed to invest a proportion of its funds, say 20%, in then stock market, the return it could generate could easily surpass 8.5%.

To do this, checks and balances must be in place to ensure that the money is invested responsibly, and professional fund managers are employed.

The government cannot afford it

True, 9.5% is too high a rate to pay in this era of low interest rates. But the truth is that the government just cannot afford to pay it. Even by paying 8.5%, there will be a big hole in the EPF.

If the interest rate had been maintained at 9.5%, the hole in the account would have been over Rs 1,000 crore (Rs 10 billion).

This gap would have to be filled by a government subsidy. In other words, the non-EPF holding taxpayers would be subsidising those who have EPF accounts.

The ones with the EPF accounts are the workers and managers in the organised sector. They account for a mere 10% of employment in this country. They are also the ones who are relatively better off compared to workers in the unorganised sector and the daily wage labourers.

So a higher-than-sustainable rate of interest on the EPF account means is that those who are relatively worse off will have to subsidise those employed in the organised sector.

That's not all---even within the EPF scheme, studies have pointed out that most of the low-wage employees withdraw their provident fund prematurely to meet permitted expenses like building a house or a daughter's marriage.

So the people who benefit from the high interest rates offered by the scheme are actually the relatively affluent within the organised sector. This is the argument trotted out whenever anybody talks about keeping the current high EPF rates.

Is there any option?

On the other hand, why should you be satisfied with an 8.5% rate when equity mutual funds easily give you three or four times that amount?

Sure, tax saving mutual funds too fall under Section 80C but you have no guarantee of return. These Equity Linked Saving Schemes are mutual funds that invest in shares of various companies and sectors. But, if the fund performs badly, you could lose your money.

The Public Provident Fund gives a lower return of 8% and has an annual investment limit of Rs 70,000.

The ideal solution would be along the lines of those who are arguing for pension fund reform. In this case, the provident fund and pension fund schemes would be thrown open to the private sector and the investor would be given a choice between the schemes.

The risk-averse than could choose a fund that invests solely in debt (fixed return investments). Others could choose a mix between debt and equity (shares), while the more adventurous could choose equity oriented schemes.

There is no reason for the government to assume that the needs of all employees on retirement are the same.