“Ashwatthama Hatha: Iti, Narova Kunjarova”, (Ashwatthama is dead: I know not whether man or elephant)

This half-truth, the latter part an inaudible murmur, by the righteous Yudhishtra led to the fall of Drona in the Mahabharata war.

Technically not false, but not the reality either. Instances of being economical with the truth abound in the modern-day financial world too. And lead to misleading, and mis-selling to, unsuspecting customers.

Many cases of mis-selling usually spring from unscrupulous agents and distributors. But product providers also sometimes tread the grey zone between right and wrong. Here’s a look at some cases where you may not get what the brochure shows, and how you can stay on guard .

Rosy annuity

Projecting higher returns than what peers offer, at least optically, is among the oldest number games of financial product providers looking to draw the customer. Take, for instance, HDFC Life Pension Guaranteed Plan launched last month. Conspicuous in the product advertisements was the annual annuity rate on the product — ranging from 9.1 per cent to 12.96 per cent. These are far higher than the prevailing annuity rates in the market (about 6 per cent). What gives?

The key fact, also mentioned in the advertisements, is that the annuity is deferred by five years or 10 years. So, in this deferment period, an investor does not earn any return on the investment and the annuity starts thereafter. On payment of a single premium (purchase price) of ₹50 lakh, the product offers a 50-year old, after five years, monthly income for life of ₹36,398. That’s about ₹4.36 lakh annually on an investment of ₹50 lakh and is the basis for the 9.1 per cent advertised by the company.

The problem is the advertisement highlighting the product’s annual annuity rate rather than its effective rate of return. Consider this: If today you invest the purchase price of ₹50 lakh in a bank fixed deposit at 7 per cent annually, you will have a corpus of about ₹70 lakh at the end of five years. The annual payout of ₹4.36 lakh on this corpus of ₹70 lakh translates into a return of 6.2 per cent, similar to the current rates in the market on immediate annuity products. Essentially, the product only offers returns similar to others in the market.

In effect, the annual annuity rates advertised for the product, by ignoring the deferment period, do not take into account the time value of money. This is something that formulae such as CAGR (compounded annual growth rate) and IRR (internal rate of return) do. They calculate the effective rate of return taking into account the time over which the investments have been made and returns earned.

Simple sleight

In India, mis-selling happens across financial products, humble term deposits included. The advertised yields on these products are sometimes exaggerated. That’s because many companies that accept deposits do not follow the conventional definition of yield. With no clear-cut rules on how yield should be calculated, many seem to be stretching the number to attract investors.

Yield, as per finance terminology, should ideally be calculated using the formula for compound interest. But several deposit-takers calculate yield applying the simple interest equation to inflate the number. DHFL, for instance, offers interest rate of 8 per cent on cumulative deposits for tenure of 120 months; interest is compounded half yearly and the company says that ₹1 lakh will grow to ₹2,19,112 in 120 months (10 years). The indicative yield is claimed as 11.91 per cent for the 10-year deposit.

The company calculates the yield thus. The formula simple interest = (principal*period*rate)/100 is re-arranged; so, rate (yield) = (interest*100)/(principal*period). The total interest earned is ₹1,19,112 over 10 years on principal of ₹1 lakh. Hence, yield = (1,19,112*100)/(1,00,000*10); this comes to 11.91 per cent. In other words, the total interest earned over the period is simply divided by the principal and the number of years to determine the yield.

But this is not the right calculation. Yield should be arrived at using the formula for compound interest: Amount = Principal*[(1 + rate)^Period]. In a cumulative deposit, the interest earned is reinvested and, in turn, earns interest in the subsequent period. These periodic additions to the capital need to be considered while calculating yield. The compound interest formula does that, the simple interest one does not. So, in the above example, 2,19,112 = 1,00,000*[(1 + yield)^10]. Re-arranging this, the yield comes to 8.16 per cent, much lower than the 11.91 per cent advertised.

There are several other instances of companies using the simple interest formula to calculate yield. Shriram Transport Finance Company has advertised yield of 9.39 per cent for its five-year cumulative deposit; if the compound interest equation is applied, it comes to 8 per cent.

It also follows that when the compound interest equation is used, there should be no difference in the interest rate and yield when the frequency of compounding is annual. There can be a difference in interest rate and yield only if the frequency of compounding is higher, say, half-yearly or quarterly.

But when the simple interest equation is used, the yield is higher than the interest rate even when the compounding is annual. For instance, the 10-year cumulative deposit of PNB Housing Finance offers 7.4 per cent compounded annually and the advertised yield is 10.42 per cent. Had the compound interest formula been used, the yield would have been 7.4 per cent, the same as the rate of interest, as should be the case.

Tax tangle

Yields advertised are mostly pre-tax. But when you evaluate an investment option, it is important to consider what you will get post-tax.

The tax angle can cause significant variations in yield. A few years back, banks such as SBI advertised yields of 16.6 per cent on five-year tax saving deposits. The rate of interest offered by the bank on this cumulative deposit at that time was 8.5 per cent. So, how did the bank arrive at a yield almost double the interest rate?

The bank considered the initial tax saving an investor in the highest tax slab of 30 per cent made by going for this deposit. For example, if an investor in the 30 per cent tax slab invested ₹10,000, he would get a tax saving of ₹3,090, making the initial effective investment ₹6,910. On maturity at the end of five years, the investment of ₹10,000 compounded quarterly at 8.5 per cent quarterly would grow to ₹15,228.

Considering the initial net investment of ₹6,910 and the maturity value of ₹15,228, the bank advertised the yield as 16.6 per cent.

The tax break does improve effective yield but it is important to note that this is pre-tax yield. Given that the bank considered the initial tax benefit on investment to show a higher yield, it should also have factored in the tax payable on the interest earned (₹5,228). Had the tax payable been considered, the yield would have declined to about 14.5 per cent.

Also, note that the bank considered the example of an investor in the 30 per cent tax slab. Investors in the lower 10 per cent and 20 per cent tax slabs get lesser yields, since the initial tax benefit they get will be smaller.

Besides, though the effective yield is high on tax-saving instruments, the cash inflow on maturity from interest based on the investment amount will be much more moderate; in this case, ₹5,228 less tax on investment of ₹10,000. Such advertisements also claimed double benefits — tax savings and high returns. This was exaggerating the case and double-counting the goodies, since it is the tax savings that lead to the high returns. Thankfully, such advertisements are not being seen these days, but be on guard against similar misleading claims.

Flat-footed

Shopping for personal or car loans, you may have come across lenders pitching rates far lower than the competition.

Before you sign in for the loan with a lower rate, make sure to ask whether the interest is calculated on a flat rate or reducing balance basis. Loans having a flat interest calculation basis may sport a lower rate. But the effective cost of such loans could be higher.

That’s because in flat interest rate loans, the interest is calculated on the initial principal amount for the entire tenure of the loan.

The mechanism does not adjust the regular repayment of the principal amount that happens along with the instalments. So, the interest is constant throughout the loan tenure.

On the other hand, in reducing balance interest rate loans, interest is calculated on the balance principal amount, after adjusting for repayments. So, the interest component in the instalments keeps reducing with time.

Here’s an example. Say, you take a flat rate loan of ₹5 lakh at 8 per cent and the loan tenure is five years. You will be paying interest of ₹40,000 a year for each of these five years and the total interest outflow will be ₹2 lakh. Say, the total loan repayment of ₹7 lakh (including interest) will happen in 60 monthly instalments of ₹11,667. Using the Rate or IRR function in Microsoft Excel, the effective annual interest cost on the loan comes to 15.1 per cent, much higher than the 8 per cent rate that you may have been told.

Now, consider a loan of ₹5 lakh with tenure of five years and interest rate of 12 per cent on reducing balance basis. The equated monthly instalment (EMI) works out to ₹11,122. The interest component on each instalment is lower than the earlier one, since it is calculated on the outstanding principal.

The total interest component over the loan tenure is ₹1,67,333, lower than the ₹2 lakh in the flat rate loan. And the effective annual interest cost on the loan is 12.68 per cent, lower than the 15.1 per cent on the flat rate loan.

So, a flat rate loan with a lower rate could turn out costlier than a reducing balance rate loan with a higher rate. Similarly, a low rate loan with advance EMIs could be costlier than a high rate loan with regular EMIs. That’s because with advance EMI, your loan amount is reduced at the beginning itself.

Card costs

Credit cards are useful but carry the risk of pulling you into a debt trap if you are not regular with payments. At 2.5-3.5 per cent per month, the interest charged on credit card dues is a staggering 30-40 per cent a year. This makes credit card debt among the costliest in the market. Then, there are late payment charges and taxes. But these high costs are not always mentioned in the card bill. Also, the rate sometimes highlighted in the bill is the monthly rate with the annual rate not mentioned or mentioned in passing; this could lull unsuspecting customers into complacency regarding payments.

Also, credit cards allow you to make minimum payment (usually 5 per cent of the total sum due) by the due date and carry forward the balance to the next billing cycle. But when you opt for this, you kiss goodbye to the free credit period. So, on the bill amount, you get charged interest right from the transaction date, and not just from the due date. Also, on new purchases after the bill date, the interest cost meter starts ticking right away. The minimum payment option can be useful if you face a temporary cash crunch. But make a habit of it and you could soon find yourself in a debt trap. While the billing statement mentions these pitfalls, it is sometimes couched in jargon and lost in the fine print.

Balance transfer from one card to another can be useful to reduce high interest costs. But these transfers often involve high processing charges that are sometimes not highlighted.

ALSO READ:Stay smart

How agents mis-sell products

 

 

comment COMMENT NOW