Monday, May 31, 2010

How to know whether you're adequately insured ?

Do you need life insurance? If yes, how much life insurance do you need? Why would a person wants to buy something that they won't be benefiting from it when they're alive?

The truth is, you don't need life insurance. However, your dependence might need it! So, purchasing life insurance (especially when it's bought for the right reason) for your dependence, be it your parents, spouse or children(s), is a very generous and thougtful act.

In this post, i'll focus on the insurance Needs rather than What type of Policy, which i've posted about it here.

First, do you have any loans that you're responsible for? For example, if you're single and have housing loans, car loans, and credit card loans, you might not need to have any insurance to cover it, since you don't have any dependant. However, if you have spouse or children or parents who depends on the house or car, then you might want to insure that loan amount.

  1. How much is the outstanding loan balance that you're liable for currently?

Next is the current needs of you dependants. Is there anybody rely on you for their financial needs? If yes, then ask yourself these questions below for each group of dependants.

  1. How much do they need from you every year (excluding loan installments, since it's covered in a lump sum above) ?
    A good start is the amount you give them currently.
  2. How many years do they need from you?
    If your dependant is your parents or your spouse, a good guide is to provide them for their entire life (age 85 and above).
  3. What is their investment rate of return, conservatively estimated?
    Note that it's "their" investment return, not "yours", since insurance company paid a lump sum (generally), and they will invest the money when you're no longer around. If they currently put most of their money in FD, then use the current FD rate.

Besides providing for current needs (as above), our dependant might have a future need too. For example, our children(s) might need a lump sum for their tertiary education. If you have any future needs, then do answer the below questions for each "future needs".

  1. What is the purpose of the future needs ?
    Examples are like Education fund, Purchase/ upgrade home, World tour for your loved ones. For education fund, seperate each child's education fund.
  2. When do your dependant needs it?
    For education fund, they would need it usually at age 18.
  3. When you're no longer around, what would your next-of-kin's investment return?
    Warren Buffett's return might be high, but when he calculates his life insurance needs, he can't use his compounded return, since i doubt his wife would be able to earn his high rate of return from investments.

With these information, your total needs can then be calculated.

Then, calculate how much is your Net Worth (excluding your home, and your car).

The difference between your total needs and your Net Worth is your shortfall, which should be covered by insurance.

If your insurance is not enough, read this post to buy the right kind of policy. I'm personally insured for RM 1 Million, payable upon Life or 36 Critical Illnesses and paying a premium of not more than RM 200 monthly, at my current age of 29.

Wednesday, May 5, 2010

Company that offers ways to reduce your housing loan interest?

Before i tell you the TRUTH behind those "The Truth about Mortgage Reduction", i would like to share with you a story:

'Once upon a time, a Young Engineer with an income of $3,000 per month noticed he had extra time (after work). Thus, he decided to use the extra time to work in Mcdonalds as a cashier, earning RM 5.00 per hour. In a month, his part-time salary was around RM 500, since he worked 4 hours a day for 6 days a week.

Then one day, he went to his Mcdonalds boss to get higher pay. The conversation was as below:

Young Engineer: Boss, how can I earn more money from this job?

Boss: Simple, just work full time here, you'll double your pay! If that's not enough, u can work full-time and over-time! All in all, you'll triple your pay! (by tripling your working hours).

Young Engineer: But if I work full-time in Mcdonalds, don't I lose my income as an Engineer (which pays higher)?

Boss: We don't count your pay elsewhere. We ONLY count your pay from Mcdonalds!

Young Engineer: Thanks! If I were to take up your recommendation (to quit a higher paying job to earn in a lower paying job), how much should I pay you for "consultation" fees?

Boss: It's only 1.5% of your total pay you'll get over 30 years plus RM 1,500. (And boss show some confusing softwares calculating how much you'll earn by working in Mcdonalds over 30 years, to confuse you that it's really worth it to pay the boss 1.5% + RM 1,500 and quit his engineering job!).

Young Engineer: Wow, that's really worth it!'

There's a few lessons you can learn from this (which I'll link to so called "Mortgage Reduction Company")

  1. There's opportunity cost for your time or your money.
    For every hour you spent earning money on one job, you've lost the opportunity to earn money on another job with that time you spent. The same applies to your money! For every dollar you spent on reducing your loan (and thereby reducing your interest charged), your money have lost the opportunity to increase your assets (and thereby lost the opportunity to earn return on those assets).

  2. Earning more by working more isn't smart!
    Smart people earns more by working more productively (spending same time, earning higher pay per hour). Likewise, when you allocate your money, what's important is NOT how much money you get (or save). What's important is how much you get (or save) in relation to how much capital you put in!

  3. Your resources (be it time or money) are limited.
    If you can earn RM 100 per hour doing a job you like, it's ok to hire person to do something you don't like for RM 10 per hour! Stop thinking about the "loss" of RM 10, but instead, compare it with the savings of your limited resources. With loan, instead of "worrying" about Debts and interest charges, compare it against the investment return that you can conservatively get elsewhere. Not all Debts/ Loans/ Liabilities are bad (then again, not all "Assets" are good). The key is not to be afraid of Debts, but to understand it, and at times, you can make use it to help you achieve an earlier financial freedom.

Now, let me get back to the main topic. Let me share with you some statements from a Mortgage Reduction website that seems to "mislead" people, and mislead them to focus on the wrong stuff.

  1. "Since this sounds like a gift from the heaven to me, I then made up my mind that one day, I could also help others to become debt free."
    Notice he uses "debt free", and not "financially free". Do you need to be debt free to be financially free? CRAP! A beggar is debt free, but is he financially free? Donald Trump might have debts more than what most people can earn in their lifetime, but he is financially free! So, STOP equating debt free with financially free!. Both are different, and a person who can't differentiate the two often find themselves stuck in rat race.

  2. "If you have a $100,000 Mortgage amortized for 30 Years with an Interest Rate of 10.50%, Monthly Compounding and the Monthly Payments are $914.74."
    As of this writing, housing loans in Malaysia charges less than 4%, while that website quote 10.5%. Isn't that trying to "inflate the interest charged" so that it looks more than what it's suppose to be?

  3. "Do you know that only $39.74 (4.24%) of the $914.74 payment is used to pay the balance? This means that a whopping of $875.00 (95.66%) of that FIRST payment goes toward interest."
    While that statement based on the interest of 10.5% interest is true, BUT that statement mislead people to focus that interest payment in relation to monthly installment. Interest charged depends on the interest rate, NOT on monthly installment!

How does the $875.00 interest come about? Easy!

  1. Your outstanding balance at the beginning of the Month is $100,000.
  2. Multiply that by the interest rate (10.5%), and you'll get $10,500. This is the interest charged in a year (if your outstanding balance is $100,000 throughout the year).
  3. Then, divide the interest charged ($10,500) by 12, and you'll get $875.00!

Notice the calculation of interest? It doesn't care what your monthly installment is! And, whatever in excess of the interest ($875), the balance goes to reducing the principal.

So, your outstanding balance reduces the following month, and thus, the interest charged reduces too (in $, but not in % of outstanding balance)!

What happens if your monthly installment is $ 5,000 per month? The interest charged on the 1st month would still be the same, which is $875 (and more than 80% of your installment goes to principal reduction!). Notice it?

If not: Here's the answer. Stop relating interest charged to monthly installment!! Instead, relate interest charged to outstanding balance (in fact, this has already been calculated for us, which is the rate told by the bank, (duh...))

And at current housing loan rate at less than 4%, the interest charged is less than half what is shown on that so called "mortgage reduction website"!


So, the question is NOT to "save" or "reduce" your housing loan, but rather to Optimize it! No point saving/ reducing your housing loan if your investment return earns better than housing loan. If you still don't understand, read the story of the Young Engineer above again.

The only way to save interest is getting lower rate from the bank! Like the Young Engineer above, the only way (that makes sense) for him to get higher pay is to increase his pay per hour, not working more hours (and lose the time to do something else!).

Personally, I'm happy to borrow maximum loan, maximum tenure, since at current housing loan rate (BLR-2.25%) , I believe my investments can conservatively earn at least twice that rate over the loan tenure (which is 40 years).

Instead of prepaying more of my housing loan to save less than 4% interest yearly, I rather invest the excess to earn at least 8% yearly, conservatively estimated. And that surplus will earn more surpluses over time, and compound the effect over time.

But if you don't know how to earn a return higher than your housing loan, then there's nothing wrong to use the surplus to reduce housing loan. Either way, comparison between housing loan's interest rate vs. your investment returns, conservatively estimated, and NOT blindly pay just to save housing loan interest!