Three questions for investors
The situation we are currently in requires tough choices. Incomes have shrunk and unemployment has risen. Households and businesses alike have cash flow challenges. Therefore, how you use your cash in hand is critical to your long-term financial health. One must know the pros and cons of making-or not making-a payment in this scenario. Often, there’s lack of clarity about what the best choice for you is. So let’s take a look at three difficult choices you may have to make during this crisis.
Pay my insurance premium or my EMI?
Whether or not to continue paying for insurance is a choice many people will be considering right now. Paying your insurance premium may impede other equally important payments such as your loan EMIs. If you find yourself in this dilemma, pay for your insurance.
Health risks are very high because of the pandemic. If you or your family members get hospitalised, you could quickly lose your hard-earned savings. Therefore, maintain health coverage for yourself and dependent family members. Don't be dependent on employer-provided insurance alone because losing your job may lead to loss of coverage.
You also need term insurance to cover life risks, which are also heightened during the pandemic. Therefore, prioritise these two forms of insurance. But then, what about your EMIs? Thankfully, the Reserve Bank of India has permitted a three-month extension of the moratorium on loan EMIs. This allows you to avoid paying your EMIs till August 31 without penalties or credit score damage. Be aware that this is merely a deferral of EMIs, not a cancellation. Interest will continue to accumulate on your dues. Therefore, use this option after weighing its long-term costs, which include having to pay several additional EMIs for a single missed EMI.
Should I continue to invest or just save?
The investment markets have been volatile. Billions in wealth has been wiped off the stock markets since the start of the pandemic. Many debt funds have had problems. Real estate is struggling. Small saving schemes, too, have seen rate cuts, and most one-year bank FD rates are in the 4-6 per cent range.
At this point, should you discontinue your investments given the volatility? This question requires a graded answer.
The difference between saving and investing is that with savings, your money is parked in a highly safe bank account, whereas with investments you need to take higher risks for higher returns. Therefore, you’ll need to answer a series of related questions the first of which is this: do you have adequate liquidity at hand?
‘Adequate’ means different things for different people, but in the current scenario, let’s say it means savings equal to six times your current monthly income. This is an emergency fund meant to bail you out of tough spots such as a loss of job, health problems and natural calamities. If you don’t have this fund, prioritise savings.
Second, if you have the liquidity, can you stomach higher risks such as market volatility or long lock-ins? If so, keep investing.
Third, can you wait for a really long time for your investment to grow? If your investment is in equities, ensure that you have a long investment horizon — five years or longer — for best returns. But if you need your money back in the short-term, or if you can’t stomach the risks, it’s best to stick to bank deposits.
Should I liquidate my investments to pay EMIs or just take a moratorium?
Another tough choice to make. In the absence of an income, you may have to break into your savings to keep paying your EMIs. This obviously hurts your long-term wealth creation efforts, and the question is should you do it or not.
If you wish to take the moratorium, you must also calculate the additional interest that a missed EMI will add to your loan.
If you decide to liquidate your savings, do check the costs of liquidation. For example, liquidating equity mutual fund units held for less than a year would typically involve a 1 per cent exit load. An FD liquidated prematurely would carry a 1 per cent interest penalty in most cases. And prematurely surrendering your endowment policies or ULIPs may lead to steep penalties.
There’s also taxation, which is often impacted by the holding period. For example, if you liquidate your liquid mutual fund units after a holding period of three years, assuming a constant rate of return of 6 per cent, your post-tax returns will be just under 6 per cent because of indexation benefits. But if you liquidate those units within two years while they are still short-term assets, your gains will be taxed according to your slab, which could go up to 30 per cent, leading to post-tax returns of well under 5 per cent. Therefore, take these costs into consideration before liquidation in order to maximise your gains.
We are going through a crisis, but when it comes to finances, we need to be calm and do the necessary calculations. This is in our best interest.
The writer is CEO, BankBazaar.com