RELATED NEWS Fear interest rate risk? Here is the solution

Most of us would have seen the game show 'Deal Ya No Deal'. The game is quite simple. The participant is given the option of either quitting the game by accepting the assured few lakhs from the banker or tries his luck to win the jackpot of Rs.1 crore by playing the game.

 

Every now and then, the life also challenges us to make such a choice - to choose between something assured and something uncertain. It asks us to choose between a situation that is safe and one that is risky, but more rewarding.

 

What should be one's strategy under such circumstances? What are the pros and cons one should weigh before saying deal ya no deal?

 

The answer lies is assessing your risk appetite. Each person is unique in terms of the income he earns, his minimum monthly expenses, his saving potential, the assets he owns and the financial liabilities he carries. Moreover, each dilemma will have a specific impact on your financial status. Therefore, it will be difficult to give a simple formula, which can solve your dilemma. However, some broad guidelines may assist you in your decision-making.

 

We look at some of the common dilemmas that we could face today.

 

Fixed rate or floating rate home loan

After falling for almost 2-3 years, the interest rates on home loans have started moving up since last 6 months to one year. Going forward also some rise in interest rates seems imminent, at least in next 3-6 months or so. But home loan tenure is usually very long, anything between 10-20 years. And it is impossible to predict interest rate scenario over such a long period.

 

Given the scenario, should one opt for the fixed rate and live comfortably without the tensions of interest rate volatility? Or should one take the risk of floating rate (which is usually a percent cheaper than the fixed rate) and hope that present rise is only temporary; the rates may come down later and you could benefit?

 

Financial prudence suggests that Equated Monthly Installment (EMI)/Monthly take home pay should not be more than 40-45%. Therefore, if your EMI, at current interest rates, is already around 40%, any hike in interest rates is going to take you to danger zone. So, preferably you should opt for fixed rate.

 

But say this ratio is only 25-30% in your case. Then you have the cushion to absorb the risk of higher interest rates. Hence, you can take a chance with floating rate.

 

Direct equity or Mutual Funds

Investing in the stock market through a mutual fund (MF) is a safer option, due to diversification. The corpus of the fund is invested in about 25-35 stocks. Therefore, while some scrips may do well, some average and some bad, overall you can reasonably expect to make 'average' returns.

 

But if you can directly invest in a few stocks, keep you portfolio concentrated to a few high growth potential stock, your returns will be far better than the average MF returns. But, of course, with a concentrated portfolio, you risk is that much higher.

 

The dilemma - should you go for average returns or try for something better?

 

Since equity investing carries a high risk, you may go for direct investing only if you understand the market very well. Second, you must be able to devote good amount of time on regular basis to research and monitor your scrips. Third, depending on your financial profile, anything between 10-50% of your equity corpus may be allocated for investing in such potentially high growth high-risk stocks.

 

Insurance or no insurance

Insurance is the cost you incur so that your near and dear ones receive financial help from the insurance company, should something unfortunate happen to you. But the probability of such an incident is low.

 

So you debate - should I take a chance and save this cost or play safe even if it costs some money.

 

Here your net assets i.e. assets - liabilities, can be an indicator. If your family's income (excluding your income) + the returns from your net assets are say about 70-75% of existing family income, you could a the insurance and save the premium costs.

 

If this works out to say around 50%, you could take part insurance cover. But if it is only 15-20%, then you could consider taking proper insurance cover.

 

Foreign trip or loan prepayment

You have received an unexpected bonus of Rs.1 lakh. You have always dreamt of going to Singapore with your wife, but were not able to go because of the costs involved. This seems like a great opportunity to fulfill your dream, as this money was anyway not expected.

 

But, on the other hand you have a personal loan to pay off. You ponder - will it not be better to repay the debt and save huge interest expense or live your dream?

 

For personal loans, it is recommended that the monthly EMI should not exceed 10-15% of your monthly take home pay. Therefore, if you are closer to this number, you may be better off repaying the personal loan from your bonus. However, if this ratio is only say 5%, have a nice trip.

 

Remember, if you want to lead a financially independent life, some risk taking is essential. Take calculated risks. Proactively manage risks. Do not always take a safe bet. Take professional help when you have a financial problem, just as you take a doctor's help when you have a health problem.

 

The author, Sanjay Matai, is an investment advisor. He can be reached at sanjay.matai@moneycontrol.com .