RBI 'tags' Loan Guarantor as Wilful Defaulter

RBI circulars are not typically "news worthy" items for common man, but it's new circular on Wilful Default created lot a flutter in the news. In the recent clarification to the master circular, RBI mentions

 In connection with the guarantors, banks have raised queries regarding inclusion of names of guarantors who are either individuals (not being directors of the company) or non-group corporates in the list of wilful defaulters. It is advised that in terms of Section 128 of the Indian Contract Act, 1872, the liability of the surety is co-extensive with that of the principal debtor unless it is otherwise provided by the contract. Therefore, when a default is made in making repayment by the principal debtor, the banker will be able to proceed against the guarantor/surety even without exhausting the remedies against the principal debtor. As such, where a banker has made a claim on the guarantor on account of the default made by the principal debtor, the liability of the guarantor is immediate. In case the said guarantor refuses to comply with the demand made by the creditor/banker, despite having sufficient means to make payment of the dues, such guarantor would also be treated as a wilful defaulter. It is clarified that this would apply only prospectively and not to cases where guarantees were taken prior to this circular. Banks/FIs may ensure that this position is made known to all prospective guarantors at the time of accepting guarantees

The primary focus of this circular is definitely companies or individuals, who acts as guarantors for other companies, ensuring bank loans despite not having enough credit-worthiness. But it seems even the common borrower is going to suffer now.

What is a wilful defaulter?

In simple terms, if a person or company is unable to repay the loan it has taken, it is terms as wilful defaulter. An exhaustive definition can be read here[PDF]. Once a banking institution, tags someone as "Wilful Defaulter", the person or company will have zero credit-worthiness and will be unable to get money on credit, apart from the possibility of legal proceeding against them. 

This is what is happening with Vijay Mallya, although he has got some favorable judgement recently. 

How does this impact a common person?

Until this circular, no one really thought much before becoming guarantor for a friend or relative, while they were availing loans. A guarantor is thought only as a referral and expected to just ensure moral liability to the person taking the loan. The provision existed for banks to pursue the guarantor for recovering of loans, but only as a last resort.

With this new circular, the banks can 

• Tag the guarantor as a wilful defaulter thus reducing credit-worthiness of guarantor to be zero
• Start recovery process of the loan from the guarantor in parallel with the original debtor. 

This is a significant power to the banks and definitely makes sense against defaulting companies, where the borrowing is several hundred crores. But for smaller borrowers who take personal loans or car loans, it is now going to be impossible to find a guarantor. 

Simple Tip : Get the EMI experience before buying that house

I am not really into buying a house (see here and here) and definitely not multiple of houses, especially via home-loan route. I have seen too many examples of people

1. Buying house and then forced to significantly cut-down their living standard
2. Getting cheated by even reputed builders (delayed projects, poor quality, document frauds etc )
3. Not really getting huge ROI (which is often the primary motive)

Yes, I know of many people, who don't enjoy life 'today' in the hope of a better 'tomorrow'. Some people take home-loans with EMI portion as high as 60-70% of their monthly inflow and then think millions of time, spending on smaller (but important) aspects of life like upgrading their car or buying new life insurance policy or a family vacation. We, Indians, are specifically tuned in "saving" mode from childhood. 

I was talking to a friend, who was very keen on buying a house in Bangalore. He was willing to take an EMI burden of close to 50% of his income. I believe that "experiencing the situation" usually helps in preparing for that tough time (think of mock interviews), so I suggested a simple method to him. I asked him to create a recurring deposit (tenure not less than a year) of exactly the max EMI he is willing to shell out.  Why a year he asked? I said, a full year will take you through all the planned and unplanned expenses that can occur like an illness in the family or a sudden trip to home-town or school fees for the kids. So he started an RD of 60K per month in his salary account. 

He came back only after two months and said its an eye-opener. As soon as his salary comes, close to 50% is gone from his account. So he has to manage the entire household expenses in the remaining amount. Six months later he prematurely cancelled the RD, but thankfully he realized that he is not yet ready to buy that house via home-loan. 

It is a simple trick but very effective to experience the burden of an EMI. As a side-effect you also get to create a good corpus once the RD matures. Try it and share your experience. 

Is your house really an asset?

If you ask this question to Indians, the answer is an emphatic yes. It is a prevalent notion that buying a house is akin to building an asset. The desire and need to own a home is hard-wired into the Indian psyche. It might be a good idea to pause and think over this question again, Is your house an asset? To answer this question, you need to define what is the meaning of an asset!! But defining asset is not easy since there are numerous definitions - two interesting ones are :

1) An asset is something that you own, where as a liability is something you owe.

2) An asset is something that generates money for you, where as a liability is something that takes away money from you.

The second definition sounds very logical and if you go by this definition, almost anything you own is NOT an asset. This controversial definition was given by Robert Kiyosaki of Rich Dad Poor Dad fame. This definition leads him to conclude that a self-occupied house is not an asset. Watch this interesting video on Youtube :

Robert Kiyosaki explaining that house is a liability!!

I don’t exactly agree with Mr. Kiyosaki even though I am inclined towards not buying a house. I believe that calling house a liability does not change anything apart from turning the traditional thought process on its head. The ultimate goal for buying an house is a) Personal satisfaction of owning a house b) Increase social status.

Indians think of the house purchase as a form of investment, which is incorrect. Let us step back and think about why anyone wants to invest their money? The whole purpose of investment ( be it in stocks, mutual funds, FDs, house or gold etc. ) is to beat the inflation and grow the money. The intention is to increase the financial net-worth so that a person can enjoy life and be mentally peaceful during any emergencies.

So is buying a house an investment? Yes and No. Let me explain this.

You may know of your friends & family who bought a house very cheaply few years back and the current price of the house is quoting much higher. But are they enjoying their current life or are they financially stretched owing to a huge chunk of earning going as EMIs? Is this sacrifice of constraint in present living state worth the investment for future self-owned house? If you are stretched too much today, then your house is definitely a liability.

Another question to ask is, when someone sells a house what happens to the money earned? Assume one of your friend bought a house for 30 Lakhs say five years ago and now it is quoting at 70 Lakhs. If he sells the house today earning a cool profit of 35 Lakhs (minus bank and other miscellaneous expenses). What happens to this 35 Lakhs? The most probable answer is that it is spent on buying another house. Did you know of anyone who sold his house pocketing a huge profit and then spent that money on a foreign trip or paid for medical emergency? In majority of cases once you buy a house, the money invested just remains as a house, you sell this to buy a bigger/better house.

If you think about any other investment, the same does not hold true. Any money earned through stocks or mutual fund immediately goes into some expenses be it for children’s education or buying that big car. But a house remains a house even across generations and the money is locked in that house. So any house bought on a huge loan only turns out to be an asset for the next generation (since they got it for free) and not for the person who bought it. I strongly believe that with nuclear family being the trend and with more globalized world, children will not care about the ancestral house and may not be living in it.

As a fact, most people who buy houses/apartments on huge loans are taking significant risk compared to the returns given by that house during their lifetime. Thus to me it implies that house is a liability.

A rough indication below will indicate that a house bought on loan cost much more than it seems :

• Down payment in cash [the cash gets locked up even before you are living in that house]
• Monthly EMI [Major portion of EMI is interest in initial years]
• Intermediary Fees [if bought through a broker]
• Miscellaneous Fees [e.g. lawyer fees, society fees, loan processing fees for banks]
• Government dues [registration fees, electricity charges, house taxes, VAT/service tax]
• Premium paid for Insurance of house
• Maintenance/upkeep for the house

An important point to note here is that typically the amount of money (interest) you pay during loan tenure to the bank, for taking home loan is approximately same as the principal (~purchase price of house). The worst part is that EMI usually follow the upward trend, as the cost of fund increases for the bank, making the house much more costly to the end-customer.

Hence buying a house may become a liability rather than an asset due to the inability of buyer to identify and understand the risks involved. This is actually true for any investments but for house purchase the stakes are much higher and risks runs much deeper.

Here are some tips to make your house an asset rather than a liability:

• Try to purchase a house which is priced a little less than what you can afford. Keep some buffer rather than stretch your finances.
• Keep a target of 100% ownership in next five years
• Buy a house which is 2-3 years old or new but fully completed. An under-constructed property is certainly more risky & hence inherently costly but it may seem cheaper upfront
• Buy a house when you can afford to pay 30% or more down-payment and plan to pre-pay the loan within 5 years
• Better to buy a house in tier-II city and rent-out the house rather than make it self-occupied in tier-I city. You can save on tax that way and also avail HRA.
• Stay on rent in good locality to enjoy your present life. The rent from your house in Tier-II city should compensate for the expenses incurred on that house.

Some related resources:

Real Estate Bubbles and California's Economic Growth  Part-1, Part-2, Part-3

Buy Vs. Rent calculator Link here

Some old posts from this blog

Link1 : How to buy apartment in Bangalore?

Link2 : Get rich by staying in rented house?

Link3 : Reverse Mortgage doesn’t work in India?

Link4 : Real estate real returns?

Link5 ; Buy Vs. Rent 

Guarantor Liability

While learning about the nomination rules for various investment avenues, I got into thinking about the rules related to being a guarantor. The term is typically confused with a reference required sometimes. It is very common to see friends asking their office colleagues or family friends to become a loan guarantor.

I am sure that most people would be very willing to help the needy friend by readily becoming a guarantor without understanding the full implication. The most common mistake happens because a guarantor is thought of as a reference. The problem is that, in the ambit of law, a guarantor is much more than just a friendly reference.

The definition itself tells a lot

“A guarantor for bank loans means a person who promises to provide payment on the loan, or other liability in the event of default.”

It is pretty obvious why banking institutions asks for a guarantor, since lending money is always a risky business with lot of chances of default by the person taking loan. So guarantor is like another chance for the bank to recover the loan money. But with a huge liability, why would anyone want to be a guarantor? A father would readily be a guarantor for his son’s education loan due to emotional reason, but others are gullible enough to not understand the liability of a guarantor and the legal implications.

What happens on a loan default?

If you are guarantor to your friend’s loan and he defaults (essentially not paying the EMI), what do you think will happen? You would think that the bank will chase your friend for the payment. Also if he is unable to pay, bank may pursue a legal course against your friend for recovering the loan amount.

Well here is the shocker!! The bank can actually issue a legal notice to you as a loan guarantor along with chasing your friend for recovery. Supreme Court indicates:

"The legal position is clear that liability of the guarantor and principal debtor are co-extensive and not in alternative," said a Supreme Court Bench comprising Justices Dalveer Bhandari and H L Dattu bursting the myth that the principal debtor had the primary liability to pay up a defaulted loan.

In plain language, the bank (or who-ever lends the money) has full right to pursue both the primary debtor (who took the loan) as well as the guarantor at the same time.

            Liability of guarantor is exactly same as that of person taking the loan.

It is important to note that a guarantor involved in a defaulting case would have a negative impact on guarantor's credit history as well. Also once a default has happened, there is very little a guarantor can do except to talk to lender and borrower and try to make a settlement.

So be very careful when providing a guarantee, since being a guarantor is akin to taking the loan yourself without getting the money.

Time Value of Money

You must have heard “Time is Money”, but do you know what is Time Value of Money? No… then blame the economists. I guess economists love to twist the common sense language into incomprehensible mumbo-jumbo to confuse the common junta.

(Picture courtesy Sam Fox)  Okay, here is another way to look at the this terminology: If you are offered 10,000 INR today or after one year, what will be your pick? Easy, huh. Only a nut-head would choose the later. But why? Well because money “NOW’ can be invested to earn more money later, or it can be utilized right now for any material gratification or who knows what will happen one year later!! What-ever the reason, everyone attaches some “time value” to the money.

                                                        

 

There are basically two reasons why people attach time value to money :

• Possibility of growing the money over a period of time
• Possibility of purchasing less in the same money over a period of time 

This simple concept becomes extremely complicated when we start applying this to practical situations. Here are some examples, where this concept is utilized:

1) How much is the present value of 100Rs paid after a year?

2) What is the monthly payment of a mortgage of Rs 200,000 at annual rate of 6% for 10 years?

3) If the investment scheme promises 10% annual interest, in how many years my present money of Rs 100 will get doubled?

4) In a different way,how much rate of interest should a scheme have if I need to double my money of Rs 100 in 5 years?

5) If I invest Rs 1000 for 20 years at 7% rate of interest, what is the final future value discounted back to its value today?

6) You are planning to retire in twenty years. You'll live ten years after retirement. You want to be able to draw out of your savings at the rate of Rs10,000 per year. How much would you have to pay in equal annual deposits until retirement to meet your objectives? Assume interest remains at 9%.

7) If you get payments of Rs 15,000 per year for the next ten years and interest is 8%, how much would that stream of income be worth in present value terms?

8) How much would you pay for an investment which will be worth Rs 60,000 in three years? Assume interest is 5%.

9) You are considering the purchase of two different insurance annuities. Annuity A will pay you Rs16,000 at the beginning of each year for 8 years. Annuity B will pay you Rs12,000 at the end of each year for 12 years. Assuming your money is worth 7%, and each costs you Rs75,000 today, which would you prefer?

10) You deposit Rs17,000 each year for 10 years at 7%. Then you earn 9% after that. If you leave the money invested for another 5 years how much will you have in the 15th year?

All these and many more questions can be answered correctly if you understand the concept of time value of money. If you are mathematically inclined, visit the wiki page or check out this video.

Buy Vs Rent

Tarak asked me

Don’t you think that staying in a rented house for long run (say 5 yrs) means waste of a huge amount. If you take 10k INR per month as rent for 5 yrs, then you are spending (5*12*10000) 6 lacks INR for nothing. Please share your view in this regard.

I think this is purely a quantitatively defined advantages of buying a house. This comment was prompted by my earlier posts on Why I think we should not buy a house? A quantitative study is important since it can help us provide valuable inputs before taking any significant decision, but should not be the only input. Consider this graphics (calculator is here).

You can do all sorts of calculations and try to predict which option, buying or renting a house, is better. But I think this is an absolutely wrong method of taking this important decision. There can not be one pill for all diseases and hence just thinking quantitatively can not be a solution for everyone to consider buying a house.

The Rent Vs Buy decision is far from just a simple financial calculation that most people get into, and it should be just one aspect of a well qualified decision.

A qualitative decision needs to keep every aspect of your life-style, both now and in future, with different priorities for each person. Here are some of the

1) Stress : Buying a house is never easy (building your own is much worse). As a tenant you can choose to end your tenancy at any point in time, but when you have issues in your house, either you have to keep adjusting or you need to go through the pain of selling the house and buying another house. If you are on a home-loan, the pain is tripled.

2) Freedom: As a tenant you are free of responsibilities, but as a owner you are not only financially but psychologically occupied. The psychological factor is extremely subjective and may vary from person to person.

3) Financial Imprisonment: It is said that you should not put more than 40% of your income into home-loans EMIs. In the world of uncertainties, job-losses and un-steady income it is a big investment and long term commitment which will certainly robe you of financial freedom. The money spent on home-loan EMI is tied up and it is not easy to access that money in case of emergency. As a tenant, you have more access to your own money and can be saved and spent with more financial freedom. It is a personal choice to become a grumpy old man with a large mansion who lived all life in financial constraints versus a happy man currently living in a small flat but who enjoyed all life with whatever money he earned. Also I am not disillusioned person who thinks my kids will be staying with me, when they grow up, in this house that I own when I be old.

4) Career Ambitions: I have heard of lot of folks, who entered executive MBA programs after 10-15 years of job. They use it as a springboard to boost their careers and ambitions. I also know lot of folks, who could not follow such career choices simply because they are tied up with their home-loans. Same goes with taking up another job in a different city or even in the same city (think of travel in cities like Bangalore and Mumbai), and people want to take up a job near their locality. If you have a house, you are definitely living in some constraints.

As I mentioned in my older posts as well that do not buy a house just because everyone is buying or it quantitatively it makes sense, think of other qualitative factors that can impact your life. Also buying a house taking home-loan is NOT an investment. An investment typically means, you want to grow your surplus money and not restricting your freedom to gain a white elephant. Here are the conclusions I wrote in my earlier post

Conclusion:

• Buy a house for living it in you old age.




• Don’t expect your children to stay with you (unless you keep them dependent on you)




• Don’t just buy because everyone is buying, think long term, where you want to settle in your old age. Timing and location are extremely important.




• Buy a house which you can maintain. In old age, it is difficult to spend huge money on maintaining big house. Security is also a concern.




• There are so many investment avenues other than house, think about that. In old age, big house won’t help, but surely the life long memories of your world travel can help. Spend money to enjoy life, and not to get imprisoned by the enormous house loan burden. Strike a balance.




• Keep accumulating small portion of money and buy a house when you are in your forties. At that age, your will be at the peak of your responsibilities, you can have your priorities clearly laid down.




• If you have loads of surplus money, then only buying a house makes sense as investment.

Home Loan Trauma, Some Tips

If you had taken a home loan in recent time, you would be an extremely worried person. With rising interest rates, you would be cursing your bank, the Reserve Bank of India, government, even Israel for raising oil prices and what not. Cursing never solves a problem, but a pragmatic rethinking will surely help. Typically when home loans are taken the household budgets are anyway streched to the hilt, so even a small increase will be felt very sharply. Instead of grunting about the root-causes of such a massive increase recently, it would really help if you worry about what your next step should be.

Facts: Interest rates are up and so is inflation. Your home loans outgo is same (without any reduction in the burden) and you also end-up paying more for the daily household items. But your salary is same.

Effects: Your incoming money is same, but your outgoing is increasing, including reduction in your investments. (an 8% return on your fixed deposit, now is earning negative since inflation is going to be around 9%)

What to do? Here are some easy steps for pondering over and including as your action items:

1) Think of those FDs or post-office investments lying around earning negatively, so why not unlock them and pre-pay your home loans. Make sure you recalculate your emergency funds and if there is an excess, use that for prepaying the loan.

2) Think about that huge amount of jwellery your wife accumulated over the period of time, it would make sense to partially liquidate it and use that to reduce your loan burden. This will give you some breather in your cash-flows with reduced home loan outgoings.

3) Re-estimate your insurance needs, if you are under-insured, seriously think of buying term-insurance to cover any unfortunate occurances. If you are over-insured, you can think of reducing few of those unnecessary policies which is eating up your expenses without much value addition.

4) Dont be a miser, but if you are into the habit of going for weekend parties or weekeend travels stop it for just few months. It doesn't cost much for each single party or travels or movies, but colelctively it can offset your increase in home loans.

5) Start a recurring desosit for next 3-4 months and whatever amount is accumulated, use that to prepay your loans.

6) Take out all of your credit-cards including the one your spouse has, keep it inside a locker. If you dont have easy access to credit card, you won't spend. This can help reduce your outgoing on those monthly credit card bills, which never seem to go away. Once you are out of this crunch you can take them out again.

7) Redution of car loans should be given more priority than home loans or education loans. You dont get any tax benefit on car loans and you are not building any asset.

Loan Calculator

If you have taken a loan and have been paying EMIs, then at some point, you definitely must have wondered about how much loan amount you have paid back (including principal amount and interest). Also sometimes we might want to know what is the percentage of principal and interest a particular EMI is paying back. This information is needed either just out of curiosity or sometimes for tax calculations. It is always difficult to get this information from banks (how much friendly the bank is) on a periodic basis.

I was in the similar situation regarding my education loan (from UBI) and wondering how can I quickly find it out myself. I just found an excel sheet on the internet (don't remember the original source, if you know please let me know), which can be quickly used to find the entire loan tenure EMIs. It is an extremely handy tool. You can download the excel sheet from here.

You just need to enter the "Loan Amount", "Interest Rate", "Loan Period" and "Starting Date"

EMI calculation using Excel

I mentioned the formula used to calculate an EMI, but putting values in the formula and calculating it is a cumbersome task. So I did some research in Microsoft Excel and found out that it can done quite easily in excel.

EMI calculation in Excel

Step 1: Open the excel sheet and locate the fx button

Step 2: In the pop-up menu, click on Financial Catergory

Step 3: In the Function Name click 'PMT'

Step 4: A box will appear as shown, fill in the values mentioned and voila you get the EMI.

Interest Component of the EMI

• Just choose the IPMT function instead of PMT

Prinicpal Component of EMI

• Just choose the PPMT function instead of PMT

How EMI is calculated!!

I decided to purchase a house in Banaglore (an extremely tough task) and the first thing that struck me is equated monthly installment or EMI. This is the single most important parameter while taking any kind of loan. This is the amount outgo every month from your personal finances which will cover both the principle as well as interest.

I talked to few people and everyone is bit confused on how EMI is calculated. It is really simple and just few steps would enable you to calculate EMI at your end.

So here is a rather simply formula for calculating EMI.

You would wonder why EMI is called "equated", the reason is that EMI is nothing but loan amount plus total interest divided by loan tenure. If that is the case then why this complicated formula. The reason is because as you keep paying EMI, some portion of EMI goes as interest but some portion goes as principal repayment. So if you pay an EMI of Rs10,000 for a house loan, not the entire Rs 10,000 would go as interest payment, but some portion goes as principal repayment, which essentially reduces the principal on which further interest is calculated. It is extremely important to understand what goes for interest and what goes for principal repayment.

It is very clear (for mathematically inclined) that when Loan Amount goes up, so does the EMI. Similarly if the interest goes up again so does the EMI, but if 'n' (loan tenure) goes up, EMI reduces. A note of caution, a low EMI for longer period does not necessary means a good bargain. A good bargain depends on your requirements as well as the total interest you pay over the entire loan tenure.

Another thing to keep in mind is whether the reduction in loan amount happens on monthly basis or yearly basis. Any loan which reduces the principal on monthly basis should be given preference. A monthly reduction implies less interest payment from next month onwards, definitely a huge savings.

Also usually interest rates comes in flavors of fixed and floating rates. A floating rate changes based on market's prime lending rate (PLR). A fixed rate stays fixed for the tenure of the loan. For a longer period of loan, my personal preference is always fixed interest rate, even if it is 1-2% higher, at least the monthly outgo is fixed, so planning of your outflows can be planned pretty well. I personally think that similar to rupee averaging for mutual funds, the floating rate almost remains same as fixed rate over a long tenure of loan. [The floating rate will go up and down and hence your monthly outgo]. And for short tenure loan, in a high interest regime, go for floating rate, but in a low interest regime choose fixed rate.