How Not To Save

By now you must have decided how to implement the 70-10-10-10 formula or a suitable variation. Just as it is necessary to know what to do with your income, it is equally important to have an idea of what not to do. And one thing that is clear in my mind is not to use Savings Account (also known as Checking Account in some countries) for saving. Savings account does not save you anything. It has the lowest interest rate (some 3 - 4%per annum) and until recently had the most cockeyed interest computation scheme.

The interest was computed on a monthly basis on the lowest balance of that month between the days 11th to the end of the month.

Example:

Date----------Balance
1st Jan ----- Rs. 50,000
7th Jan ----- Rs. 1,000
10th Jan --- Rs. 100,000
15th Jan ---- Rs. 2,000
25th Jan ---- Rs. 500,000

In this case, the monthly interest will be computed on Rs. 2000.

This has thankfully now changed. The interest is now computed on a daily basis on the minimum amount per day. See here.

That said, even this does not make a Savings Account very attractive. Savings account should only be used for parking your money temporarily. As a rule of thumb, I would recommend that at any given time no more than 1.5 months salary be parked in such an account. With intelligent use of credit card (yes, credit cards can be used intelligently) the maximum amount to be parked in a Savings Account can be brought down drastically.

Escape the Curse of Credit Card

In my last post I showed you how deadly the credit card can be. Once you get into the credit cycle, you end up paying much more than you bargained for.

Does that mean you should throw away your credit card?
The answer to that is very simple: No you should not. Rather you need to use it with wisdom.

Here are two ways to escape the curse of the credit card.

1) Keep a track of what your expenditure. I always assume that the money paid by credit card belongs to this month's expenditure. It is easy to keep a track now-a-days. Banks let you see your credit card statements whenever you wish to - not just at the end of a billing cycle. At least, my bank, Standard Chartered, has that facility. Regular checks on your credit card will also help you look out for any credit card frauds.

2) Do not use the credit facility of the Credit Card. Pay your entire amount every month. One way to force this on yourself is to give a standing instruction to your bank to pay off 100% of the amount.

Of course, you could also use the Ice Glass Method

The Curse of The Credit Card

Credit card is a potential drain on your earnings. It doesn't seem so, but it is. You tend to spend more when you shop with a credit card. The removal of actual cash passing your hands to another desensitizes you. And all the small purchases add up when the credit card bill comes knocking you door. But there is something more pernicious in credit cards. And that is the minimum payment clause. Why do you think the bank / credit card company allows you to pay only a part of the total. It is not that they love you. It is because it gives them more revenue.

Let's see how it works.

Assume you have made a purchase of Rs. 100. You are allowed to make a minimum payment of 10%. You have to pay for the outstanding amount at 2.5% per month (yeah, it is per month). But there is another twist here. The interest free period disappears when you make a part payment. So you actually pay interest on the Rs. 90 from the day you make a purchase. Suppose you decide to pay off the whole amount in 10 months, you end up paying Rs 11.25 extra. Not much you say? I would loath to pay Rs. 11.25 on every Rs. 100.

But consider this. You not only pay 2.5% on the amount outstanding for the original purchase, you also pay 2.5% on any purchase you make in the payoff duration - even if you pay off the entire amount for the purchase within the billing cycle.

Let us take a simple example. This is your purchase and payment pattern

Month--Payment-----Outstanding-------Purchases------Interest
------------------------------------------------------------
Jan----Rs.100
Feb----Rs.10---------Rs.90------------Rs.1000--------Rs.2.25
Mar----Rs.1090-------Rs 0-------------Rs 0-----------Rs.27.25

Basically, you end up paying for the Rs 1000 for the month of February even though you paid it off without carrying anything forward.
Deadly, isn't it?

By the way, 2.5% per month does not work out to be 30% per annum. It works out to be approximately 34.5%. You might as well take a consumer loan from the bank at 12.5% and pay off the outstanding amount on credit card.

Reduce that debt

Coming from a middle class background, I was always wary of debt. My parents were never in debt. They postponed acquiring luxury items, but never borrowed money to buy that refrigerator and the colour TV (both purchased from a matured insurance). Besides, those days, India had not yet seen the consumer boom. Credit was not easily available.

Then things changed. Banks now call and ask if you need loan at easy (easy?) installments. You could buy anything on credit card and pay only 10% of the outstanding (never mind the HUGE interest you pay). Instant gratification is the name of the game.

But, hold on. Is debt such a bad thing?> I could not have purchased a house or my dream car (not every one dreams of a Ferrari or a BMW; some of us dream of Scorpio too) with borrowing from banks. Besides, many companies have debt ("a healthy debt to equity ratio").

So why it is that I have against debt. And it is not just my background. I don't think so. To be get onto debt if and only if you have an investment that is paying you more than you are paying for the debt.

Let me take an example. For most Indians, buying a house is beyond our means. We need to borrow money from the bank. The house will be yours for Rs. 32,00,000. Let's assume you have the paying capacity to borrow Rs. 22,00,000 @ 9% interest. You could have paid Rs 12,00,000 from your pocket but since bank is ready to pay that much amount, you put in Rs. 10,00,000. My question to you is: what would you do with the Rs. 2,00,000 left with you. Are you keeping it for some contingency? Or are you going to invest it in an instrument which returns you more than 9%? If you are saving it for some unknown contingency, you have not been reading my blog. Get an insurance, man!
If the Rs. 2,00,000 is not yielding you (after tax) more than 9%, you are just wasting that money. You are better off, taking Rs. 20,00,000 from the bank.

Explore other avenues. Do your parents have some money to spare. Perhaps they can lend you some money. They might have a fixed deposit that is paying them at 6.5%. Take that money and pay them at the rate of 7% (they may refuse to take money from you; but you should insist). Does your company offer loans at low interest. Take that. Reduce that debt.

Put it this way: Given a choice I would like to buy that centrally located house or that spanking car from the fruits of my investment. Ideal. Failing that I would reduce my debt as much as possible

Escape from the clutches of credit card

In my last post I talked about impulsive purchases and breaking barriers of reluctance. Credit cards are instruments that help you spend unnecessarily and spend more. Since you do not see your net worth reducing, you get psychologically inured to overspending.

One way to escape this is to avoid the temptation to increase the credit limit of your credit card. I deliberately ignore mails from my bank to increase the credit limit. In one case, the bank increased the credit limit on their own because I am their valued customer. Yeah sure! I also carry just one credit card. I have surrendered all others I had.

I just read something called the ice glass method for reducing credit card spending. The following extract is from Predictably Irrational by Dan Ariely.

[The Ice Glass Method] is a home remedy for impulsive spending. You put your credit card into a glass of water and put the glass in the freezer. Then, when you impulsively decide to make a purchase, you must first wait for the ice to thaw before extracting the card. By then, your compulsion to purchase has subsided. (You can't just put the card in the microwave, of course, because then you'd destroy the magnetic strip.)

Go figure.