These days, a sum of Rs 1 lac looks like this –
Fixed Deposit for Rs 1 lac @ 9% per annum with monthly interest payout
= Rs 9,000 per annum in interest earned before tax
= Rs 750 per month in interest earned before tax
= Rs 672.75 per month in interest @ 10.3% income tax slab
= Rs 595.50 per month in interest @ 20.6% income tax slab
= Rs 518.25 per month in interest @ 30.9% income tax slab
Since I’m currently in the highest income tax slab, each bundle of Rs 1 lac that I save moves me in the worst case Rs 500+ per month closer to my ere-goal. Save two bundles and I’m suddenly Rs 1,000+ per month closer to my ere-goal.
Psychologically, I think this breakdown into smaller targets seems to have spurred me. Rather than thinking along the lines of “Oh! I still need to save X-gazillion number of rupees and God alone knows when I will get there,” I now have started to think along the lines of “Oh! I only need to save Y bundles and I’m there.” Somehow this line of thinking helps.
Of course, it’s not possible to save a whole new bundle each month but if I can save a good number of bundles per year, all of a sudden that ere-goal doesn’t look all that far away…
Posted on a slow Friday afternoon. And I realize that I am dreadfully overdue on announcing the winner of the September Book Giveaway.
About a week back, I received a PR email from IDBI Bank announcing the launch of their Floating Rate Term Deposit scheme. Thought I’d look it up and give you a quick review (a side effect being the evaluation of this scheme for it’s suitability in my ere portfolio).
- To begin with, if things such as a 364-Day Treasury Bill, average yield, interest rate outlook, etc. don’t really make much sense to you, then it’s a good idea to stay away from this product. This investment has a lot of underlying technicality and is suitable for you if and only if you understand all of that. I’m really glad that IDBI Bank states this upfront in the product literature. To quote — “FRTDs are ideally suited for the financially literate investor, who is not averse to taking a call on the directionality of future interest rates/inflation.”
If you’re still reading, I’ll assume that you’re a pretty savvy investor. So, I’m going to highlight some of the nuances that aren’t readily inferred from a casual read of the product literature.
- The minimum term is 1-year and the minimum lock-in period is also 1-year. That’s a disadvantage because given the current market scenario, you’d definitely want to have as much financial flexibility as you can. You don’t get that when premature withdrawals aren’t allowed for a year.
- The base interest rate is reset each quarter but the mark-up (what you get over and above the base interest rate) is only reset once every year. While, the base interest rate is pegged to the 364-Day Treasury Bill, the mark-up seems to be an internally calculated number. So, while you can have your personal opinions about the T-Bill rate movement, you don’t have even that choice on the mark-up. I think the mark-up would be adjusted to keep the total interest rate competitive in general to what’s available from other Banks.
- I couldn’t determine what would happen if, for example, you open a new FRTD on, say today, 03-Sep-2012. Would your interest rate be reset at the next fixed quarterly reset point of 01-Oct-2012 or at the point when your FRTD crosses a quarter (on 02-Dec-2012). I’m guessing it’d be the former but it’d be better to clarify with the Bank.
- Personally speaking, I won’t be taking this up for my ere portfolio. Vis-Ã -vis fixed deposits, I’m currently doing much better elsewhere and with a monthly payout (the FRTD offers a quarterly payout and the other thing I’m not sure about the product is whether the interest accumulated is compulsorily paid out each quarter).
Here’s some additional information from the mailer –
The product is likely to appeal to the retail investors who borrow at floating rates (say, for home loans) but invest at a fixed rate, and are consequently exposed to high interest rate risk. FRTDs ensure that their loans and deposits move in tandem and would help to partially immunize their asset-liability portfolio from such risks.
Investment in FRTDs is also beneficial when the interest rates are expected to rise as it enables the investors to take advantage of periodic increase in the market rates. In a rising interest rate scenario, the customers generally go in for short term deposits and keep rebooking them as and when interest rates move up. FRTD would help do away with this cumbersome process.
- I contest the first argument because say when home loan rates go down why would you want your deposit rates to also go down in tandem? You’d always want to earn as high as possible on your deposits no?
- I contest the second argument because there’s no published logic for calculating the mark-up.
That said, do you think this product has a place in your portfolio?
I’d love to hear your thoughts.
In my most recent early retirement update, I’d published the below chart –
This chart illustrates potential monthly income earned and actual expenses incurred as a function of time over the past four-quarters. I’d explained these terms further by saying –
When I say potential income, I am referring to any passive income plus the income that I could potentially generate by liquidating all of my low-liquidity and medium-liquidity investments, consolidating it into one corpus, and earning a monthly interest off this corpus at an assumed average rate of interest. My first target is to have at least two successive quarters where the income line is above the expense line. Now, that would be something!
After I wrote that article up, I
began thinking could not stop thinking why “just potential income?” By now, I have saved-up a pretty decent corpus. So, what lucky star am I waiting for to fall from the skies? Why don’t I actually start earning that monthly interest right away and see how much of that “potential” is really “actual”? The interest rates are pretty high and solid right now (especially around the 24-month tenure). So, I can actually begin to test the waters of early retirement while I continue to earn a pretty good salary from work.
These incessant thoughts got my head into a high-rev mode and I began to dig deeper into options that I could explore for generating a steady monthly income (because after the what, why, and when of a financial goal the real pain lies in the how to get there). I considered –
- Fixed Deposits with monthly interest payouts
- The Post Office Monthly Income Scheme
- High-interest Liquid Mutual Funds
- Monthly Income Plans from Mutual Funds
- [And to some extent even] Annuities from Life Insurance Companies!
Each of these options has its own idiosyncrasies — investment style, lock-ins, income tax efficiencies or lack thereof, and so on. For example, you’re not really guaranteed a monthly income by a Monthly Income Plan from a Mutual Fund, the Post Office Monthly Income Scheme guarantees a fixed monthly income but locks-up your money for five years, an Annuity from a Life Insurer guarantees a fixed monthly income for quite a long time but you don’t get to see your money ever again, and so on.
All of that brainstorming and research was frankly overwhelming — seriously, once you get into the passion of early retirement, it starts to take a life of its own! To come back on track, I started to question my real intention — was it “To test the waters of early retirement?” or was it “To build the most optimized early retirement portfolio?” And that was pretty easy to answer. I really only want to test the waters of early retirement and therefore I simply settled on a “Think BIG, Start small” strategy.
So here’s what I’m going to do (or have already started doing) in the coming days –
- Accumulate all of my high-liquidity savings and investments into a single corpus (say X). Most of these are anyway nearing maturity and so I don’t have to prematurely close anything.
- Keep X/2 in fixed deposits with a monthly interest payout. I’m shooting for the 24-month tenures (or approximately, because in some cases 24-months plus 1-day gets you a higher interest rate!). But, on an average, the monthly payout seems to cause a discount of 0.07% on the published interest rates. So, if the published interest rate is 9.25% you’ll end up receiving 9.18% simple interest with the monthly payout option.
- Keep X/2 in high-interest Liquid Mutual Funds (my research suggests that the yields here are a bit higher than what you get on the 24-month fixed deposit). Then withdraw exactly the interest (or gains) earned each month and add it to the above monthly payout.
- Try to live off this investment income plus the passive income from a couple of other sources and figure out how to make ends meet. I foresee this to be a serious challenge — given the current pretty indulgent salary-based lifestyle (and that’s also why I want to test the waters of early retirement from this aspect as well).
- I also want to retain the flexibility to discard this strategy at any time should it not work as expected (and the above investment choices would give me the needed flexibility). I’m also currently OK with having to pay any income tax that needs to be paid on the investment income. After all, my primary objective beyond everything is to test the early retirement waters from all angles.
- As some of my other investments mature over the next couple of quarters, I will divide the proceeds equally between the above two investment vehicles. I’m also going to add all savings from my salary in the same proportion. The intent is to keep growing the monthly payouts.
- Finally, overarching is the support and commitment that I have from D for this experiment.
I think it’s going to be a great challenge.
What do you think? Can you spot any drawback with this strategy?
Here’s an unusual financial planning conversation I heard from a colleague at lunch today –
Seems my colleague wanted to get a borewell dug at their residence. But when the contractor visited her premises for a site evaluation it was discovered that the compound wall of the house had to be torn down in order to accommodate all of the digging machinery. So when all the costs (including reconstructing the compound wall) were added it ran up to around Rs 200,000.
Here’s what my colleague reasoned –
Rs 200,000 in a fixed deposit would yield around Rs 18,000 per year at 9% rate of interest. That’s about Rs 1,500 per month or Rs 375 per week on an average. The cost of a tank’s supply of water in that area is around Rs 300 — Rs 350 and that water lasts for about a week. So, it makes no financial sense to go ahead and dig the borewell. Not only does the interest earned from the fixed deposit cover the cost of external supply of water but you get to keep the principal amount as well (rather than it becoming a sunk cost and really sunk if the borewell were to run dry).
Following-up on my previous post where I illustrated through a real-world example the way to calculate the maturity value and effective yield on a five-year tax saving fixed deposit (FD), I hacked-up a simple Android-application that helps you do the same in an instant wherever you are.
Click here to download the 5-Year Tax Saving FD Calculator Android-application. If you’re adventurous enough, it’s an unsigned .apk file that you can quickly install and run on your Android-phone (I’m still figuring out other mobile platforms). Let me know if you run into any trouble â€” it should run fine on most Android environments.
Here’s a quick screenshot of the application –
Here’s a quick usage manual –
- Enter the Amount that you wish to invest in the Tax Saving FD of your choice.
- Enter the Rate of Interest published by your Bank.
- Click on the Calculate button. The Maturity Amount (of maximum interest to you) is auto-computed and shown.
- Choose the Income-Tax bracket that you come under.
- The Effective Annual Yield is auto-computed and shown.
Couple of real-world examples –
Here are two recent advertisements for 5-Year Tax Saving Fixed Deposits. In both cases, I believe that the Effective APY of 17.77% shown in the ad for a Rate of Interest equal to 9.25% is wrong. (unless I am missing something?) The results however do tally for a Rate of Interest equal to 9.75%.
Let me know if you found this application useful.
In the past one year, my Fixed Maturity Plans (FMPs) have fared only slightly better than my Bank Fixed Deposits (FDs) of comparable tenure.
- A 1-year FMP from IDFC achieved an APR of 10.05% (equal to an APY of 10.44% with quarterly compounding).
- A 1-year FMP from SBI achieved an APR of 9.89% (equal to an APY of 10.26% with quarterly compounding).
- A 1-year FD from HDFC Bank achieved an APR of 9.25% (equal to an APY of 9.58% with quarterly compounding).
Ignoring the complexities of investment timing and income tax, that’s less than a percentage point in difference! Have you seen anything different with your FMP and FD investments?
Here’s how you do the APR (simple interest) to APY (compound interest at a certain compounding interval) conversion.
If you’re totally lazy to the APR to APY conversion by hand, here’s a quick Android-application that I hacked. If you’re adventurous enough, you can download the .apk file and install it on your Android-phone as an unsigned application. Let me know if you run into any trouble — it should run fine on most Android environments.
This article was originally published as exclusive content for my facebook subscribers and is now being republished to reach a wider audience. Subscribe to my facebook feed and be the first to read more such exclusive content.
Quite a number of readers had written in asking me to explain the difference between APR and APY.
APR = Annual Percentage Rate. Think of this as simple interest.
APY = Annual Percentage Yield. Think of this as compound interest.
APR and APY explain why your Fixed Deposit certificate quotes an interest rate of 9% but upon maturity you get an interest amount that is slightly higher than what you’d actually get at 9%.
APY = APR compounded at a certain compounding interval.
The exact formula that relates these two is:
APY = (((1 + (Quoted_APR/100)/Compounding_Interval)^Compounding_Interval) – 1)*100
Look at this illustration (click on the image for a full-size version).
When APR = 10.25% and compounding is done quarterly then,
APY = (((1 + (10.25/100)/4)^4) – 1)*100 = 10.65%
On the other hand, if APR = 10.50% and compounding is done quarterly then,
APY = (((1 + (10.50/100)/4)^4) – 1)*100 = 10.92%
Finally, if APR = 10.25% and compounding is done semi-annually then,
APY = (((1 + (10.25/100)/2)^2) – 1)*100 = 10.51%
That explains the difference between APR and APY. Let me know if you have any questions.
Note: With Credit Cards you might sometimes see a monthly-APR quoted such as 3.1% per month. Simply multiply this by 12 to get the annual-APR. In this case, the annual-APR is 3.1% x 12 = 37.2%.
A reader had written in some time back asking me if investing in fixed deposits issued by companies/corporates was a good investment idea. Here’s my take:
- You should think about investing in company fixed deposits only when you have some surplus cash that you’re prepared to lose should the worst were to happen.
- Be prepared to do some independent research on the company. If the company in question is already drowning in debt but the investment prospectus talks about raising money for expansion, you wouldn’t want to handover your money to them would you?
- Don’t be swayed by the brand name. A company fixed deposit from a well-known brand doesn’t automatically mean it’s a good investment avenue for you.
- Don’t be swayed by Investment Ratings/Grades from Ratings Agencies. They generally don’t mean much to you — it’s not as if anyone is guaranteeing anything to you by giving out such a number.
Can you add to this list?
Reading through my backlog of emails, here’s what I found:
Why would I ever want to break my ultra-safe Fixed Deposit(s) that currently earn a handsome 9% — 10% per annum and instead invest my money in something that’s much much riskier (AA-!) and only assures me up to 12.50% per annum? The risk premium ought to be much higher than a measly 2.50%. Hike that up to 5.00% and I might consider investing some spare money. But I wonder what’s the spread on this one. I also wonder what the money mopped-up is being used for.
Hope you haven’t broken your Fixed Deposit(s) for this one.
A colleague asked,
I want to set aside an emergency fund purely to handle any loss of employment situation that I might face. What would you recommend?
Here’s what I recommend:
- First, estimate your monthly expenses (including EMIs, monthly savings for annual expenses, and routine household expenses). Let’s say this amount is M.
- Structure a 6-month fixed deposit ladder (i.e. one fixed deposit each month for six months with each fixed deposit maturing in six months). Each fixed deposit should have it’s face value equal to M.
Now suppose you do lose your job. You only need to wait for that fixed deposit with the nearest maturity date to mature, close it, and use the proceeds for your monthly expenses. Of course, once you’re back in a job, you will need to put the ladder back in place. I also believe that the interest you earn will more or less account for any inflation, but when you don’t have a job, concerns about inflation should be the last thing on your mind. What should be on your mind, however, is frugality.
How does this strategy sound?
A friend asked,
I’m in the midst of changing jobs and have opted to withdraw the savings in my Employee Provident Fund. It’s a decent sum — around Rs 300,000 — and I wish to keep this money safe. Is there a way I can achieve this and yet earn a steady income?
My immediate answer was a fixed deposit with periodic interest payouts, but my friend has been investing in tax-saving fixed deposits and was looking to diversify. My next suggestion was the Post Office Monthly Income Scheme. And, in case you don’t need the monthly income, automatically roll that amount into a Recurring Deposit.
What would you suggest?
A reader asks,
I’m being offered an upfront joining bonus by my new employer. How should I go about investing this money? There is one condition though. I will be required to give back this money if I leave the job within 6 months.
Given the payback condition, I’d recommend that the joining bonus be kept in a 6-month fixed deposit — don’t even think of investing it right now. If you do leave the job within 6 months, you can break the fixed deposit and give back the money to your employer. And if you don’t, the money is fully yours and unencumbered and you need to use/save/invest it to meet your financial goals.
What do you think?