How to increase Savings when Income is constant? - Part I

So far we have seen how to measure the combined returns of one’s asset mix, called the portfolio, understand the difference between nominal & real returns and took a further step to examine the 3 different types in which assets are classified. In this issue, we are going to look at increasing your savings, while keeping income constant, by plugging the leaks on the expenditure side.

Income – Savings = Expenditure

Most of you may be familiar with this arithmetic, “Income – Expenditure = Savings”. The problem with this math is expenses being variable, savings too becomes variable. This is not good for your financial health in the long run. So, it is important to first select a certain fixed percentage (10% or 30%) of your income as savings and then spend the balance.

Leak 1 – Insurance policies

Insurance is required only to compensate you for any loss, other than term & medical policy, rest are not required for an individual. Insurance is not an investment, there is no such thing as saving through an insurance policy. So, in a bid to save tax, do not keep buying insurance policies that you do not understand. The nature of the product is very complex, returns/bonuses are unpredictable and it is one of the most mis-sold instruments in the country. So, save yourself from creating a recurrent leak.

Leak 2 – Rent (vs) EMI’s interest

Just as the rent that you pay never comes back to you, the interest part of your EMI too never comes back. So, when going for a home loan, ensure that the interest part of your EMI does not significantly exceed your rent payout.

Lets say Vijay earns Rs.70000 p.m. And he is evaluating 2 loan plans - Loan-A at Rs.30Lac / 15 years tenure / EMI Rs.30000 p.m. Loan-B at Rs.60Lac / 30 years tenure / EMI Rs.47000 p.m. Vijay would be re-paying a total interest of Rs.24Lacs on Loan-A and Rs.1.1Cr on Loan-B over the respective loan tenures. This means he is paying a monthly average interest of Rs.13k on Loan-A & Rs.30k on Loan-B, which he would never get back.

If Vijay is currently paying a monthly rent of Rs.15000, Loan-A might be right for him. He could possibly stretch his loan to Rs.40Lacs, paying an average interest of Rs.18k p.m. In case he stretches it to Rs.60Lacs in Loan-B, it could lead to the biggest wealth destruction for him. We shall see about this in detail in a future article.

Leak 3 – Home Loan Pre-payment

Many of us get bonuses each year during the tenure of our home loan. How many of us utilize it to pre-pay the loan and how many of us use it to buy a vehicle/white goods/jewellery?

Lets say Raj has a home loan for Rs.30Lacs / 15years / EMI Rs.30k. And he used his bonus of Rs.6Lacs to pre-pay his home loan, in the 4^th year of loan tenure. This translates to a savings of Rs.8Lacs in his total interest outgo – I.e, it plugs 33% of his leak in interest outgo.

Although your bank makes it difficult for you to pre-pay or foreclose the home loan, go in for a pre-payment - even a smaller amount of say Rs.2Lacs helps you to save a big leak. The secret here is to make maximum pre-payments within 1/3rd of your loan tenure – I.e if you have a 15 year loan tenure, try to make smaller pre-payments before the 6^th year to reduce your interest liability by 30-50%. Multiple home loan pre-payment(s) is your best aid in wealth building.

Leak 4 – Vehicle

Similarly, when your home loan EMI is active, try avoiding additional big ticket loans, especially one for a depreciating asset like vehicle. Try to car-pool or use cab-hailing services such as ola & uber. If you must buy a car, go for a re-sale vehicle. This way you could instantly save 30% on your purchase, say you could get a Rs.7L car at Rs.4.8L and plug in the high interest leakage on your car loan.

Do these changes really make a difference?

Long term wealth building is always about making every financial decision count. If you save Rs.8Lacs interest outgo from your home loan in the 4^th year like Raj and invest it in equity mutual funds, it could be worth Rs.26 Lacs (at 12% p.a return) by the time your home loan ends.

Instead if you get caught unknowingly in an ill-structured home loan, you forego yourself of the opportunity to increase your portfolio value by Rs.26Lacs. Similarly if you are mis-sold an insurance policy, you lose the opportunity to double your money immediately. Such is the power of plugging big leaks – they help to increase your savings even if your income is constant.

We’re going to see how to plug 4 more leaks in the next issue!