Life Insurance is a 4 Letter word…continued

Yesterday I wrote about whole life and term life and why I think whole life is good and how I have started appreciating the benefits of whole life as I have aged.

One of the argument which I used to hear against endowment plans and whole life plans was that you could take the same life cover at a much lower value by taking a term plan and the difference can be invested in a mutual fund which will give a much higher return.

There are a few challenges that I have been able to figure out in this logic. If you know of others please let me know in the comments below.

1. With term insurance you don’t get any money if you survive the term, that’s a complete loss.

2. Mutual fund or stock market returns are not guaranteed. In the endowment policy you are guaranteed a minimum value at the end of the term. You may get a higher sum because of bonuses, but a certain minimum is assured.

3. When you sell your stock the amount attracts long term capital gains tax. The money you get from the insurance policy is generally tax free in quite a few countries both for you and after your death for your survivors

4. In most countries investing in mutual funds or stocks does not get you a tax rebate while investing in insurance does.

If you don’t have the financial capability to take an endowment or whole life plan, take a term plan. Take it as early as possible and take it for the highest value feasible. Getting the highest coverage on your life is absolutely necessary. Don’t ever think that Mutual Funds can cover that risk.

However once you have some lee way in your finances, start whole life and endowment plans to create predetermined cashflows.

Use mutual funds or stocks to give you growth in the very long term where the compounding kicks in.

This has been a learning for me and I would not like you to make the same mistakes that I did.

Till next time then.

Carpe Diem!!!

Fractional Reserve System

Banks, cash flow, Debt, Leverage, Liabilities

When I was a kid, I always wondered how banks operate. Yes I did know they take money from us and lend it to someone on a higher interest, compared to what they give us. The difference in the two helps them make money. Because they allow you to keep the money on “tap” they give almost negligible interest rates. On longer duration deposits they give a slightly higher rate of interest because the chance of the money being asked earlier is reduced.

While this is simple I still could not understand how banks could lend so much money and how defaulters could have so much money with them.

A few years back I was sharing a ride from Indore to Bhopal – two cities in the state of Madhya Pradesh in India – with a banker. During this 4 hour journey, I happened to get talking with him on the same query. His logic partially answered my question.

The logic was that at any point in time the banks don’t allow you to withdraw All the money from a savings bank account. So they will put clauses – that in case you need an ATM facility then you need to maintain a certain amount, if you need a cheque book then you have to maintain a certain minimum amount in the bank, otherwise they penalise you. Due to this there is always money available to the bank even in savings bank deposits which will not go out of the bank in most situations. This becomes one source of low value funds. In addition there are the long duration deposits etc.

This had partially answered my questions but I was still not able to get my mind to understand how these deposits can create such high value lending capabilities for banks.

I don’t know if you have heard this term Fractional Reserve System before. If you have, then the remaining part of the post will be uninteresting to you. I first read about this in the book Second Chance by Robert Kiyosaki. Then I did some research on Google, Wikipedia etc. This got me most of the answers.

So now over and above what the banker above told me, the banks are allowed to lend a “multiple” of their deposits of various kinds. The key word is multiple. To ensure that the banks don’t go “bust” in most countries they have to hold a certain amount of their deposits with a central bank so that there is always a safety net for the depositors in case the debtors default and a bank has a run on their money.

Due to the ability to lend multiples of the deposit rate , say just for argument sake 10 times the deposit rate – if a bank has 1 million retail customers who have to maintain a minimum deposit of $100 then they have $100 million (1m*100) as the amount which would generally always be available to the bank. Now because they are allowed to lend 10 times the deposit rate, they can therefore lend $100m *10 = $1000m.

Since they always get a much higher rate on lending, and they only pay out a much lower level of interest to the depositors, the difference is huge amount of money for the bank. So on the 100m they are paying 2% per annum – which will mean giving out 2m as cumulative interest to the depositors. On the other hand they may lend at 10%. So 10% of $1000m is $100m. So at a gross level the bank has just made $98m using your $100m. I am sure there are other expenses involved, I have used 10 times just for demonstration purposes.

The challenge for the bank is when people default on paying their loans and the amount is much higher than the deposits. Therefore banks ask for collateral to protect their downside.

This was such a huge revelation for me because this is such a huge cash generator. They have so much leverage on the money which you have lent to them with very little liabilities. The key in this is the ability of the bank to have a good process to understand risk on a loan. This is why I now remember in one his interviews Raamdeo Aggarwal of Motilal Oswal, mentioned that if you want to buy the shares of a bank look at their loan underwriting process. The stronger the process the better the bank in getting its money back and the higher the profits.

I get elated when I am able to solve a query which has been at the back of my head for such a long time.

Let me know if you have had Aha moments when a query which has been long standing gets solved.

Till next time then.

Carpe Diem!!!

Using debt to grow rich

cash flow, Debt, Liabilities, possibility thinking

I had written two posts a few days back on the difference between debt and liability.

As a middle class person, the word debt has a lot of negative ideas. I have had so much credit card debt , housing loans etc. that the very idea of taking a loan or using a credit card is an absolute no-no.

Garrett Gunderson gave a very good explanation of debt versus liability which I explained in the posts earlier. I also wrote in those posts how I am trying to get my head around the ideas of utilising loans – loosely called debt to grow. I did understand the concept that if you are buying a productive asset, to buy that asset you will incur a liability. As long as your assets are more than your liabilities, its not debt. If you invest in productive assets and those assets generate cash to take care of the liability then there’s absolutely no problem.

I came across one video of Robert Kiyosaki – of Rich Dad Poor Dad fame – where he talks about how the rich actually love debt. But he makes a very clear distinction. They have teams who understand and manage the debt such that they are consistently extracting the maximum out of the asset to produce cash and pay off the debt.

This way they are able to grow their assets much faster. They then use the assets to generate more cash, pay of the liabilities / debt and start the cycle all over again. Since they now also have the asset, they are also able to use that asset as collateral to get more loans to expand further. If the assets are non-depreciating like real estate or intellectual property then its even better. What this gives the rich people is leverage to grow faster. it allows possibility thinking. Therefore the rich are growing richer.

This is something which I need to think of, because my middle class mindset is still a little sceptical. Robert also has a caveat to this theory. He is clear that its not ok for everyone to use debt because its a double edged sword. If you don’t have the guts to handle this kind of a double edged sword, then you should avoid debt at all costs.

Tell me your views on the topic in the comments section below. I will look forward to hearing from you.

Till next time then.

Carpe Diem!!!

Velocity of Cash – Part 2

cash flow, Financial Independence

A few days back I had written a post on this topic. I have been working on seeing how the same money, multiplies itself just based on the velocity it can get.

FMCG companies are a perfect example of creating wealth due to the velocity of cash.

On a typical tube of toothpaste or a bar of soap, each of these companies only makes a few cents. But because they sell to the distributors in bulk and realize their money, they invest it back again in making more and selling more.

Their model is primarily driven by volume even though the per unit margin is very low.

If you look at these companies they generate so much cash, they give out such huge dividends on a consistent basis only because of their ability to generate velocity on the cash.

Cash if it’s kept stagnant in your home cannot generate wealth. Wealth can only get generated when cash keeps moving. If it’s moved into consumption items then it generates wealth for that entity. If it’s moved into productive items, then it will create wealth for you.

One of my philosophies of buying stock , similar to Peter Lynch, is to buy stocks of companies whose products I consume, so that some of the money that I spend comes back to me in dividend and capital appreciation.

Till next time then.

Carpe Diem!!!