Money Advice that can make a Big Difference

Sarah Ramcharitar answers your questions on choosing a bank, saving, taking a loan, and other financial stuff.

What are some of the factors that should be considered before taking a loan from a financial institution?

Just as we should be physically and mentally healthy we also should be financially healthy. One aspect of being financially healthy is to ensure that we do not (as the old folks say) “stretch our hat where we cannot reach”. We should not incur debt that we cannot repay.

The borrowing process should be a tool of financial strength rather than that of financial detriment. Once used wisely, we can propel the use of debt financing (a.k.a. loans) to be in a position of asset ownership and improved financial strength. But for us to reap the rewards of engaging with loans we need to understand how they work.

First determine: Is the purpose of the loan justifiable? Am I borrowing to take a vacation, get married, purchase a car, get an education or buy a house? Each of these situations resonates in a different way, with different people.

Carefully analyze the purpose of the loan. Is the loan object a necessity? Something that you need now? Or can you save some more funds, and borrow later?

Consider all the alternatives to purchasing the item? If the necessity is a car, for instance, which you can’t exactly afford at the moment, did you consider carpooling and/or paying someone a small amount for chauffeur services, until you’re more equipped to make the purchase? Albeit this option is not particularly part of our culture, it is often overlooked.

Other considerations: Is your salary secure enough? If the amount you borrow is based on your current earnings (as opposed to amassed savings, inheritance, or other income) you must earn the equivalent of your salary or more over the entire loan period. If your job is not secure, you should be careful when borrowing. Think, if I lose my job in one year’s time, how would I pay off my loan?

Your income should be large enough to cover your loan payments as well as existing commitments. Determine whether existing loan payments account for between 30% and 40% of your available monthly funds. If your existing payments exceed this amount, you should work on clearing off current debt, before engaging in new debt.

What is the real cost of the loan? There are always additional costs to consider. For example, when purchasing a car we need to cater for insurance costs, maintenance costs, fuel costs. Can your salary support all these extra expenses?

Your car starts losing value, and depreciates significantly in the first year. Thus, is it wise for buyers to take a low interest loan over 5 years, as opposed to a 3 year plan?

Most assets we purchase depreciate in value, land being one of the few assets to appreciate. Therefore, car depreciation over time should not be a deterrent to buying. A car serves an invaluable purpose by providing us with immediate access to transport, which some consider to be priceless. That said, it’s always better to take loans for shorter periods as this cuts your overall costs. But the question is: Can your cash flow facilitate the larger monthly loan payments that come with the shorter-term loan?

The general rule is that your total loan repayments should add up to 30% to 40% of your monthly income, maximum.

If a buyer cannot afford to pay off their car within 3 years, do you recommend that they buy a less expensive car, or that they purchase the vehicle they want, even though they would continue to pay interest on a car after it has depreciated in value?

Regardless of the method or length of financing, all vehicles depreciate in value over time. A car does not lose 100% of its value after three years unless it is written off. Therefore, it is financially okay to take a loan for more than three years, let’s say five years, to purchase a vehicle; but one must ensure that finances facilitate loan repayment during those five years.

The price you pay should reflect the type of car you actually need, the reliability and quality of the car, your ability to resell the car and its potential resale value. Consider your commitments (present and future): salary level, potential for increased salary, job stability, and ability to repay. Once you’ve determined your needs, and assessed your commitments, you can make a more informed purchase decision.

Is there a simple formula one can use to assess the value of the vehicle, compared with the total amount that the purchase would cost after the loan period?

There is no set formula but you are faced with one guarantee – that the value will be less at the end of the loan period than at the start. The loan period affects the cost of financing, whilst car valuation is generally determined by market value.

As a general rule of thumb, insurance companies assume that cars generally depreciate (or lose value) by an average of 15% after the first year and thereafter 10% every year. But, in actuality, you need to assess the mileage of your vehicle from year to year, the quality and type of vehicle and the manner in which the vehicle was maintained over the period. Any anomalies in those factors can cause the car to lose more than the usual value.

What are some key questions that a person should ask their financier when considering a loan?

Be sure to shop around for your loan; ask these questions to various lending institutions:

What is the total cost of the loan?

Interest is not the only cost involved. There are other costs such as loan processing fees, payment protection/loan insurance fees, late payment fees, and early repayment fees. Know and understand the full range of costs you can incur. Ask for a detailed listing of all the charges involved.

What is the method of calculating interest?

The Annual Percentage Rate (APR), or effective rate, is different from the stated rate of interest, depending on the method of calculation. When talking interest with your bank officer always hold them to a position of disclosing the total interest in dollars, which will make for a common ground for comparison and understanding.

Is my interest ‘tied to prime’ or is it fixed over the period?

Asking this question helps you to understand the potential for increases in the cost of the loan. A ‘tied to prime’ loan is one where your interest rate increases every time the bank’s prime lending rate increases. Ask that your loan rates be fixed for the duration of the borrowing period.

Can I get a copy of a loan amortization schedule?

Following from the first two questions above is the need to understand that when you make a monthly payment a portion gets allocated to interest and a portion gets allocated to the principal balance of the loan. The amortization schedule gives you an outline of every loan payment to be made and shows the distribution between the principal and interest. Why is this important? Say, for example, that you took a house loan. The loan is so structured that payments made in the earlier stages are allocated mostly to the interest component and the principal balances only reduce minimally until the later stages. This happens when financial institutions take the bulk of their interest up front. Therefore, if your loan is so structured, and you want to pay it off a few years earlier, what you would be doing is actually using the money you now have to pay off for monies that you were already charged to borrow for the duration of the loan.

Can I make lump sum payments toward principal or early repayment without penalty?

Banks rely on a constant stream of payments, including interest payments, over a period of time for their own financial purposes. Therefore, if you agree to pay off a loan over a five year period, and then decide to pay it off early, early repayment penalties usually apply. These penalties provide compensation for your financier’s loss of future cash flow and income from your loan. Find out whether these penalties apply to you, and ask to be exempted. You need to be in control of when you want to clear off the loan and how fast you want to do so.

What is my monthly payment?

Although some people think this is the most important question, it’s actually the least. Financial institutions offer low monthly payments to make loans attractive. Remember: the lower the monthly payment, the longer the repayment schedule, and the higher the cost at the end. If you are forced to accept a longer term and lower monthly payments, due to affordability concerns, then you need to reassess your need to take a loan at the current time. The loan may end up costing you more than if you’d waited until your cash flow improved.

What collateral do I need to provide?

Usually the asset being purchased is used as collateral. However, if the purpose of the loan is to effect house repairs, you may ask if this condition could be waived so that you can take an unsecured loan. Once you are providing collateral to the financial institution, understand that this is a form of security for them. You can be in a better position to bargain with them–depending on the quality of the collateral–for better interest rates.

In your view, is the bank still the best place to stash your cash?

Before you decide to stash your cash in any area, whether at home under the mattress, on the stock market, in insurance companies or in the bank, you need to understand yourself as an investor —your preferences and goals. Your savings should be regarded as a portfolio, made up of a variety of investment instruments: some long-term, some medium term, some short term, some with high returns and others with low returns. After a full understanding of your needs, the size of your “stash” and your affinity for risk, you can determine your portfolio.

In our current economic climate, you should aim for security rather than returns. This means that you should keep your “stash” where you can access it when you need it, rather than placing it in areas where it would earn higher interest or returns and risk losing it altogether. After all, the higher the returns the greater the risk.

Granted, your “stash” in the bank will not bring you much returns—at the moment banks offer very low interest rates (from below 1% to maybe 2%) depending on the term, amount and instrument. But in an investment climate like this you have to say to yourself, “That’s ok, when the economy is better I would change my strategy, redesign my portfolio and invest elsewhere”.

However, when putting money in the bank, bear in mind that the Deposit Insurance Corporation of Trinidad and Tobago only insures your deposits up to $75,000 at any one bank. Depending on the value of your “stash,” it may be wiser to spread it across banks.

How does inflation affect your bank account?

Inflation very loosely is the economic term that refers to the general rise in prices of goods and services in an economy over a period of time. It does not specifically affect the amount of money in your bank account. However, it directly impacts the purchasing power of that money; the so called “basket of goods” your money could buy, diminishes as inflation rises.

Just for your knowledge, according to the CIA World Factbook, as of January 2011, the consumer price inflation rate of Trinidad and Tobago was 11.3%, ranking 24th in a world ranking of 221 countries, whereas Barbados was 5.5% and ranked 75th.

What are some common often overlooked ways of saving big?

Before I get into a few short suggestions about saving, I would like to make a blanket statement that we do not have to be misers to be savers. We can live very vibrant, full lives, spend wisely and still manage to save without “missing out” on things. We need to know ourselves, and what we want; and not spend due to ego, image and/or peer-pressure. Saving is fundamentally a psychological process facilitated by financial methods.

I think the most common overlooked way of saving big is credit card management. Most of us use credit cards and utilize the minimum payment option to pay our monthly bills. But consider this for a moment: Your normal living expenses (food, clothing, entertainment) totals $10,000 on your card. The average bank in Trinidad & Tobago charges credit card interest at 24% per annum or 2% monthly, and has a minimum payment of 5% off the balance. Plug these figures into an interest calculator found on creditcard.com and the results are staggering. It would take you just over 10 years, and cost over $6,000 in interest, to pay off this balance (assuming no further purchases have been made with the card). We often haggle over the price we pay merchants to save a few dollars but turn a blind eye to the amount we pay the bank. The next time your credit card statement comes, I urge you to go to the calculator, get a good eye opener as to your personal position, and reconsider how you manage your credit card payments.

Budgeting: I can actually feel the complaints of readers as I write this portion. “Oh, I’m not an Accountant!” “Oh, this is not a company, just my salary!” But despite that I will go on to say that a lot of savings can come from spending wisely. Take some time (even if you take pen and paper whilst on the loo) and list your sources of income and all your expenses. Think carefully about each expenditure item and ask yourself if the purchase is absolutely necessary. If we were really sincere about looking at our actual expenditure versus what we should be spending, I am sure we would be amazed at how many purchases we could do without. One of the best ways to ensure you save consistently is to treat your savings as an expense. So when doing this exercise write down a committed figure to savings. Each month transfer your savings amount to a separate account (most banks facilitate these monthly transfers at no service charge) and on the days when you need it the most – you would be thankful you have it. Most of the larger corporations facilitate transferring of salaries to two banks, so why not ask your employer if they can send a stipulated amount each month so that your saving occurs at the time of earning?

Purchasing breakfast/lunch daily or regularly: I guess it is only through my own personal experience with this that I can convincingly say that this is another source of overlooked savings. Consider that the average breakfast will now cost about $10 to $15 and lunch between $25 to $35. Most working people buy breakfast and lunch for most of the work week, so we are talking about $500 to $1,000 per month depending on frequency. What I have learnt is that we pay a very dear price for the convenience of not preparing our meals ourselves and on top of that, we most times throw out about a quarter of the purchased meal.

Over the last few years, I’ve become quite adept at preparing meals in advance. Even if it means a sandwich and cereal and home filtered water in a water bottle, every day I leave home with my meals and drink. Thus, I avoid the lunch time hassle of buying food and waiting in long lines, and generally have a more relaxed lunch hour and even the occasional, eat while I work. I’ve also noticed that I am more aware of my food choices and eat a lot healthier than I did when eating out. Mind you I still manage to get in the occasional eating out with friends and family when I choose to. To help me manage this aspect of my life better I consistently prepare meal plans every week, so I know what I need to buy at the grocery and what needs to be prepared when. After doing this for a few weeks, you would find that you can rotate the same meal plans which further reduces hassle. It is a well accepted fact that menu planning saves time, money and improves nutrition. All that is needed is the will to do it.

- Sarah Ramcharitar (BSc (Hons);FCCA)