Add-on Rates Revisited

DEAR INVESTOR JUAN

Dear Investor Juan,

I just got a loan for 450k 36months to pay.. I see a per annum rate of 28.58% but she was saying something about 1.29% per month add on rate.. Im confused, mind explaining it to me the add on rate?

Thanks,
Mon


Dear Mon,

I have already discussed the difference between add-on rate and the monthly compounded interest rate (such as in credit card debt or home and car loans) in this post, but I will try to explain in again and apply it to your situation.

With add-on interest, the quoted monthly add-on interest rate is multiplied to the principal or loan amount to get the monthly interest payment. For the monthly principal repayment, the loan amount is divided by the loan duration. In your case, therefore, the monthly interest payment is 1.29%*450,000 = 5,805, while the monthly principal repayment is 450,000/36 = 12,500, and the total monthly payment is 5,805 + 12,500 = 18,305, an amount that you would have to pay every month, as seen in the spreadsheet below. If you scroll down to the bottom of the sheet, you'll see that at the end of 36 months, you will have paid a total of 658,980, of which 208,980 is for interest. Further down, you'll see that the internal rate of return or IRR, a way to compute for return or interest while considering the timing of payments, is 26.72%. This is not exactly what your bank representative quoted, but this may be what she was talking about.



Now if we were to take the same monthly interest rate of 1.29% but this time apply it as a monthly compounded rate in an amortized loan, then we'll see a different payment schedule. Please refer to the spreadsheet below.



To get the monthly payment (or "amortization") of this kind of loan, we have to use the PMT function of Excel or any spreadsheet program, where "rate" = 1.29%, "nper" = 36, and PV = -450,000. The resulting figure is 15,705, which is the amount that is paid every month until the 36th month. In the first payment, 1.29%*450,000 = 5,805 goes to interest, same as in the add-on loan, so 15,705 - 5,805 = 9,900 goes to principal. The following month, the principal goes down to 450,000 - 9,900 = 440,100, which will then become the basis for this month's interest payment of 440,100*1.29% = 5,677. Do you now see how this kind of loan is different from your add-on loan?

With monthly compounded interest loans, principal repayments are deducted from the principal, the lower principal balance becomes the basis for interest computation, and interest payments decline (and in the case of amortized loans where the monthly payment is constant, principal payments increase) as the end of the loan period nears. With add-on interest, monthly interest payments stay the same even as part of the principal is repaid every month. And this is why, at the same "monthly interest rate," add-on interest loans are more expensive than monthly compounded debt.

I hope I was able to explain the add-on rate sufficiently, Mon. Good luck.

Housing Loan Lump Sum Payments

DEAR INVESTOR JUAN

Dear Investor Juan,

I hope everything is well with you.

Are you familiar with loan amortization? My wife and I have a housing loan with a term of 20 years. Our goal is to shortened that to at most 15 years. We have discussed this with our bank and they said that they don’t usually reconstruct loan. We can try but it has a high probability that we will not be approved. So they suggested to us to pay in lump sum every annual repricing. There is no minimum amount for the lump sum payment but their suggestion is it has to be at least 6 times of our monthly amortization if possible so that it can also somehow lower our amortization. It will probably take us 2-3 years to save that amount of money (around 100k). Is it wise to do that or paying in lump sum every year even if it is only 30-50k a wiser move?

We got a fixed interest rate for the first 3 years. I can easily compute the amortization in Excel via the Loan Amortization template. I don’t know what will be the computation for the repricing in the 4th year and onwards that is way I can’t come up which is better. J

Here is the sample data that I used in computing for the amortization for Year 1 to 3 using Excel.

Loan Amount: 2,000,000
Annual interest rate: 7.88%
Loan period in years: 20
Number of payments per year: 12

Is this the correct computation for year 4?

Loan Amount: 1,860,550.26
Annual interest rate: 8%
Loan period in years: 17 ???
Number of payments per year: 12


Thank you so much.

Danison


Dear Danison,

So your objective is to shorten the term of your housing loan from 20 to 15 years by either paying a lump sum of 100,000 on the fourth year or annual payments of 30,000 to 50,000.

Using the information you have provided me, I have reconstructed your loan amortization schedule here. You have a 20-year loan with an annual interest rate of 7.88% (we'll get back to this later). Using the PMT function of Google Spreadsheet (same as in Excel; "Current" worksheet, double-click cell B4 to see the inputs), we can compute for the monthly amortization of your loan: 16,580 pesos per month. If you  paid down payment on your loan, you should actually deduct it from the loan amount, and it will give you a lower amortization. Also, the resulting amount does not include insurance and other fees, so it may differ a bit from what your bank quoted.

The monthly amortization amount is what you have to pay every month to pay off your loan. Every month, a portion of it is used to pay for the interest of your loan, and the remainder goes to the repayment of principal (see the formulas for the cells in the "Interest payment" and "Principal payment" columns. So every month, a portion of the principal is repaid, the loan balance gets smaller, the interest payment correspondingly decreases, and a bigger portion of the amortization goes to principal. In the "Current" worksheet, you'll see how much of the amortization goes to interest, how much goes to principal, and what the loan balance is every month. At the end of 20 years or 240 months, you'll see that the ending balance is zero and the loan will have been completely paid off.

Now go to the "Lump Sum" worksheet to see how much impact a 100,000 peso payment will make. If you make a lump sum payment, the entire amount will go to principal and this will accelerate the repayment of the loan. To see how it will affect the schedule, just manually add the amount to the "Principal payment" cell for the month of your choice. Here, I assumed that you will make the payment at the end of Year 3.

If you go to the bottom of the worksheet, you'll see that with this lump sum payment you will be able to completely pay off the loan at the end of Month 219, or near the beginning of Year 19. So it seems that you would have to make more lump sum payments if you want to completely pay off the loan by Year 15 (Month 180). Feel free to play with the spreadsheet and add whatever lump sum amounts you think you can afford to achieve your goal.

In another email, you mentioned that the interest rate of your loan will be readjusted for Year 4 onward. In the "Adjusted Rate" worksheet, you'll see how a different rate will affect your subsequent payments. You're currently in Year 3, so with the recent credit rating upgrades, you should expect a lower readjusted rate next year (I assumed 6%).

Anyway, I know that I did not really answer your questions, sorry about that, but rather gave you a tool that can hopefully help you find the answers yourself. Good luck!

In case anyone missed it, you'll find the spreadsheet here.

7 Pillars of Financial Literacy, Explained (Part 2)

In Part 1, I delved deeper into the first four "pillars" of financial literacy. In this post, we'll take a look at the remaining three pillars and see how they fit the "bigger picture."

5. Managing debt

A lot of people think that "debt is bad," but it isn't--at least not necessarily. Debt is an essential feature of the economy and society-at-large because it serves as a bridge between those who have excess funds and those who need funds. If people and institutions can't lend to or borrow from each other, then excess capital will remain idle and unproductive, economic opportunities will be unexploited, and personal needs unmet.

Debt is "bad" only if: 1) a substantial portion of the borrower's earnings go to interest and principal repayments; and/or 2) the borrower cannot afford to significantly reduce the principal balance of the debt in the foreseeable future. When one or both of these situations arise, the borrower is left with limited spending power for a considerable amount of time, or even indefinitely.

There are several ways of avoiding this "debt trap." First, remember that borrowing only makes sense for certain purchases or situations: a house, a vehicle, and some consumer durables (such as a personal computer, some appliances) if you can justify the purchase and if you can afford the payments; and emergencies. Borrowing for investments is okay only if you can earn returns that sufficiently cover interest, after considering the riskiness of the investment. Needless to say, it's a bad idea to borrow for things that you don't really need, or things that don't "last" (e.g., weddings, trips, parties). Second, if you're going to borrow, look for the lowest interest rates that you can get (for which you need to understand how concepts like add-on interest and simple vs. compound interest work) and avoid very high interest rates, such as what you get if you don't pay your credit card bill in full every month (more than 50% per year effective interest) or if you borrow from loan sharks (anywhere from 5% to 20% add on interest per month). Finally, if you're going to borrow, apart from the interest rate, ask for a quotation of required monthly payments and make sure that these are sufficiently covered by your income less essential expenses.

6. Investing

Once your "expensive" debt has been paid off and you're amply protected by insurance and cash (see Pillar #4 in Part 1), you can start setting aside capital for investment. Investing involves spending money now for the possibility of receiving more money in the future (which is what sets it apart from "saving," where you just get the same nominal amount in the future). Please note that I said that there's only a possibility of earning from an investment--"returns" are never certain, no matter what anyone says. In fact, for a lot of investment instruments there's also a chance that you'll lose a portion of your investment. The possibility that you'll earn less than what you expect or even lose some amount is called investment risk.

Investments may be broadly classified as "passive" or "active." Passive investments mostly just require capital, in exchange for periodic income (such as dividends or interest) and/or capital appreciation. Some examples of passive investments include financial instruments (stocks, bonds, mutual funds, UITFs), real estate, and speculative instruments like currencies and precious metals. Active investments such as business ventures require time as well as capital from the investor; as one of the founders of the business, the investor needs to spend some time in planning, forming, and establishing the venture, and often also in running/managing the business. Entrepreneurial ventures are covered in greater detail in the next item.

In evaluating investments, an investor needs to consider several factors which we label here as "SHORE": Scrutiny – Do you understand the mechanics of the investment? Are the company and business model sound?; Horizon – Can you afford the lockup period of the investment?; Objective – Does the investment fit your financial goal?; Risk – Are you aware of and can afford to take the risks involved?; Experience – Can you take advantage of any existing experience with this type of investment?

7. Starting and running a business

Starting a business does not just go from a great idea straight to the SEC for business registration. Some questions need to be asked first: What's your business model? How will your business make money?; Who are your customers?; What are the risks involved?; What's your exit strategy?; Are the expected profits worth the capital required and risks involved? Once you have figured out the (best effort) answers to these questions, you organize your ideas into a "business plan."

The next step is to figure out how to finance the venture. Can you cover the required capital on your own, or do you look for partners? Is it a good idea to borrow? If yes, from whom?

Finally, being an entrepreneur involves not just shelling out investment capital, but also making important business decisions. For this, a certain degree of understanding of business processes and activities is necessary. The entrepreneur must try to familiarize his or her self with the following "functional areas" of business: Finance - raising capital for projects; Accounting - keeping track of the business's finances; Operations - managing production and/or processes; Marketing - selling the firm's products/services; and Strategy -  making long-term business decisions.

There you have it: the Seven Pillars of Financial Literacy. I hope you'll find these past three posts helpful in charting your way through the deep and wide, sometimes muddy but always enlightening, realm of financial literacy. As always, comments and feedback are most welcome. Enjoy the rest of the week and have a great weekend!

A Closer Look at SMIC's 15 Billion Peso Bond Issue

DEAR INVESTOR JUAN
IN THE NEWS
PERSONAL FINANCE 101

Dear Investor Juan,

I am Manny, an OFW from Qatar, one of your new readers and I admire your willingness to share your knowledge. I'm also new to investments and I would like to request for your opinion and analysis and explanation of an article I read in Philippine Daily Inquirer about SMIC's bond issue found here. I like to know what phrases like "scripless form at 100 percent of face value," "indicative interest rate will be a maximum of 6.2115 percent a year for the seven-year bonds," and others mean.

I hope you can find time to explain these, not just to me, but also to all your readers.

Thank You.

Regards, 
Manny


Dear Manny,

Thanks! I'm glad that you find the website helpful and interesting. And thank you for sharing this information with us.

I've already discussed bonds to some degree of detail in prior posts (i.e., "The Ins and Outs of Bonds" and "Pricing Bonds"), but this issue presents a good opportunity for me to discuss some things that I haven't talked about yet and emphasize those that I already have. So let's go through these details one by one.

1. "It will be SMIC’s first time to offer retail bonds since 2009 when it issued P10 billion worth of bonds."

Corporate bonds are typically available in denominations that are beyond the reach of individual investors, running in the neighborhood of hundreds of thousands of pesos. Retail bonds, on the other hand, are more affordable since they are available in denominations of 10,000 pesos or so.

2. Based on documents from the SEC, SMIC’s bonds will have a term of seven and 10 years with a base offering size of P10 billion and an option to increase by P5 billion in case of oversubscription.

Term (or tenor) of a bond is the number of years from the issue until the issuer (or borrower)--in this case SMIC--has to pay back the face value or the borrowed amount (from the point of view of the investor, the invested amount) to the investor/lender.

3. The proposed bonds due 2019 and 2022 will be issued in scripless form at 100 percent of face value. 

For several years now, publicly-traded securities like bonds and stocks have been issued in "scripless" form, which means that investors are not issued paper certificates of ownership anymore; instead, ownership is just recorded (electronically) on the "books" of the broker.

4. Prior to final redemption, SMIC will have a one-time option but will not be obligated to redeem the bonds in whole. The redemption option is open on the 10th interest payment of the seven-year bonds and on the 14th interest payment for the 10-year bonds.

Just like this East West Bank issue I discussed two years ago, these SMIC retail bonds are "callable," or include a "call option." This option gives the issuer (SMIC) the right but not the obligation to buy back the bonds at a certain price (face value + a certain premium) for a specified period of time (from the 10th interest payment for the seven year bonds and from the 14th interest payment for the 10-year bonds). The issuer would benefit from exercising this right if and when interest rates fall within the specified period, since it will then be able to buy back the bonds at a price lower than the prevailing market price.

5. Indicative interest rate will be a maximum of 6.2115 percent a year for the seven-year bonds based on PDST-F benchmark as of May 21 and 6.975 percent a year for the 10-year bonds. 

The indicative interest rate is the return you will most likely earn per year, before taxes, if you invest in the bonds and hold them to maturity. You will know the actual interest rate when you actually buy the bonds.

There you go. I hope you find my answers helpful. To help you decide whether to buy these bonds or not, you might want to take a look at my past posts about other investment alternatives and risk and return. Good luck!

Add-On Interest: Don't Let the Numbers Deceive You

PERSONAL FINANCE 101

Say you want to buy a new laptop worth 30,000 pesos, but you don't have cash at the moment. You can finance the purchase one of two ways. You can use your credit card to buy the laptop, and be charged 3% interest per month for any unpaid balance. Or, you can get a personal loan from the credit cooperative in your office: the interest rate on such a loan is 2% per month. Which financing alternative would you choose?

The easy and obvious answer is the personal loan: from the perspective of the borrower, the cheapest credit alternative is always the best, and it seems pretty straightforward that the 2% personal loan is cheaper than the 3% credit card debt. However, as you may have already judged from the not-so-subtle clues I have laid out so far, getting the personal loan would actually cost you more than if you just used your credit card for the purchase. Why, and how, you ask? It's because interest on personal loans are almost always quoted and computed as "add-on" interest, which is different from how interest is computed for credit card charges and other types of credit. This difference could be enough to offset any advantage one option seems to have over the other, based on quoted interest rates, ultimately resulting in bad decisions like in the example above. You'll see how the two are different by looking at how interest in computed for each alternative.

Payments for Loans with Add-On Interest

We first need to specify the parameters of our personal loan example. The principal is 30,000 for the laptop, add-on interest is 2% per month, and let's say you plan to pay off everything in one year. Monthly payments for loans typically have two components: principal repayments and interest payments. Loans with add-on interest is paid in equal installments every month, and principal and interest payments are also constant monthly. The principal repayment portion comes from dividing the principal by the number of payment periods; in our example, it's 30,000 / 12 months = 2,500 pesos per month. You get the interest payment by simply applying the add-on rate to the principal: 30,000 x 2% = 600 pesos per month. Therefore, to pay off the 30,000-peso loan in one year, you have to pay 2,500 + 600 = 3,100 pesos per month for 12 months.

One odd feature that you may have already noticed in the preceding computations is that the add-on interest rate is always applied to the original loan amount, even if a portion of the principal has already been repaid. This is the primary reason why add-on interest loans are more expensive than other kinds of debt, all other things equal, as you'll see when we compare the payments for the two types of credit.

Payments for Credit Card Debt

Unlike loans with add-on interest, monthly payments for credit card debt are not predetermined or fixed; each month you can choose to pay any amount that is greater than or equal to a set minimum. Also, unlike add-on interest loans, principal repayments reduce interest in future periods, as is also the case with other kinds of debt.

To illustrate, let's say you use your credit card to buy the 30,000-peso laptop. For comparable results, we assume that you decide to pay 3,100 pesos every month, the same amount you would have paid if you took out the personal loan instead. The interest on your debt after one month would be 30,000 x 3% = 900 pesos. If you pay 3,100 pesos that month, 900 would go to interest, and 2,200 would go to the repayment of principal. Which means, at the end of one month, the balance of your debt would be reduced to 30,000 - 2,200 = 27,800 pesos. In the second month, the 3% interest rate would be applied to the balance from the previous month, 27,800 pesos, resulting in a lower interest payment of 834 pesos. Again, the remainder, 3,100 - 834 = 2,266 pesos would go to principal repayment, leaving you with a balance of 25,534 at the end of the second month. Continuing this process though the 12th month would result in the following loan repayment schedule:

With credit card debt, unlike add-on interest loans, interest declines with the decreasing principal balance, resulting in a lower total interest payment of 5,977.53 pesos (versus 7,200). This proves conclusively that the credit card alternative is cheaper than the personal loan, even if the latter features a lower quoted interest rate than the former.

Finally, the above example shows that if the credit card debt costs 3% interest per month, then it follows that the "true" monthly interest rate of the personal loan would be higher than that (definitely not 2%). How much higher, exactly? The only precise way of computing for such an interest rate would be with the use of a financial calculator or with Excel. We can get the effective monthly interest rate of the loan by using the the internal rate of return or IRR function of Excel (just like what we did in this past post about time value of money):

The result is monthly rate of 3.475%, which is close to 1.5x the quoted add-on rate of 2%.

How much interest would you actually be paying in a year with the personal loan? Multiplying 3.475% per month by 12 months (41.7%) would underestimate the effective annual rate since interest is compounded monthly (I'll explain what compound interest is in a future post), so it would be more appropriate to do it this way: effective annual rate = (1 + 3.475%)^12 - 1 = 50.67% per year. And that is why you would effectively be paying more than 50% interest per year on a 2% per month add-on interest loan.

Financing Your Business Part 2: Debt

DEAR INVESTOR JUAN

Perhaps the most important reason why you, as a business owner, would want to (partly) finance a venture with debt is that you want to maintain majority or sole ownership and control of the business, which may be significantly diluted if you instead use additional equity financing, as was discussed in Part 1. Also, as I already mentioned in that post, while the business entity would have to be formed first (and in many cases, be in operation for a number of years) before a business loan gets approved, the entrepreneur can always use personal debt to supplement the initial equity raised.

Having said that, here are the most common sources of debt financing for budding entrepreneurs.

1. Credit card debt. Yes, I'm not joking: you can use your credit card to finance some of your business's capital needs. Not only that, it can be your cheapest source of financing if you play your cards right. Remember, you only get charged if you don't pay the entire balance on or before the due date; so the key is to use your credit card to buy some of your business needs, like say, your monthly inventory if you're running a sari-sari store, and pay the entire balance on the due date. Doing this is like getting a one-month loan at zero interest rate every month; as a deal, nothing can be sweeter.

Of course, paying beyond the due date comes at a terribly high price: credit card financial charges in the Philippines run at around 3.5% per month, or 42% per year (annual percentage rate or APR). So don't even bother using your card if you know you won't be able to wipe out the balance every month.

2. Cooperative/payday loans. If you're currently working, ask your more seasoned officemates the going rate for payday loans or for loans offered by your office credit cooperative, and you'll hear that it's anywhere from 1 to 5% per month (by the way, this is add-on interest, which is applied differently than the monthly compounded interest rate of credit cards); while not as high as the infamous "five-six" rates offered by loan sharks, 5% per month is still quite expensive. Still, you might find these loans useful because they are readily available and the application is usually hassle-free.

3. Loans from government offices (SSS, GSIS, Pag-ibig). Not a lot of people know this, but you can actually use all of those deductions you see on your paychecks to your benefit as early as two years after the start of your employment. For example, you can get a two-year, 24,000 peso loan from SSS at only 10% per year. Also, apart from housing loans (best rates in town if you're going to borrow 1 million pesos or less, by the way), Pag-ibig also offers multi-purpose loans and calamity loans to its members. Far from being worthless, these government agencies can boost your debt capacity and strengthen the capital base of your business.

4. Bank loan (personal). Sometimes banks offer really low interest rates for personal loans, like less than 1% per month, add-on, with borrowed amounts that can range from 10,000 to 500,000 pesos. The problem is, the application period may take some time, and there's no certainty that your application will get approved (I know a couple of people who have already been turned down even if they're capable of paying back the loans).

5. Bank loan (business). If your business is already up and running, and you need additional financing for expansion purposes, for example, you can get either a line of credit or a business loan from a bank. With a line of credit, an amount you apply for will be made available to you for a specified period of time; when you need the money, you can borrow or draw funds from this line at a predetermined interest rate, and you don't have to submit an application every time you borrow. SME business loans, like the ones offered by BPI and DBP, generally requires collateral.

In getting a bank loan for your business, it would help immensely if you already have a long and meaningful relationship with the bank, even just by maintaining a considerable deposit balance. With this kind of relationship with your bank, there's a higher chance of getting your loans approved, getting lower interest rates, and even securing a business loan for your new business.

6. SME business loans from other financial institutions. Like the ones offered by Small Business Corporation (SBC) and SSS. SBC even offers debt financing for startups, so just make sure that you have a sound business model and a well-prepared business plan for your new business. You can probably even get lower rates from these institutions than what most banks provide.

To end, just remember two important things before you borrow money for your business. One, by borrowing, you will be committing your business to a fairly large business expense (interest plus principal repayments), so make sure that you can generate enough cash flow (not profits, mind you) to meet these future needs, or your business falls to ruin. Two, even if you organize your business as a corporation or a limited liability company (each of which provides owners with limited liability for business debt, meaning creditors can only run after the assets of the business), almost all commercial lenders will require you, as the owner of a new or small business, to personally guarantee the loan with your personal assets through what is called a surety, a guarantee which essentially wipes out your limited liability. In other words, before you borrow any amount for your business, be ready to lose your shirt (and maybe your underwear too) if you're unable to repay your debt.

Answers for Thursdee, Part 2: BPI Family's Plan Ahead Time Deposit, T-Bills, and Bonds

DEAR INVESTOR JUAN

As promised, here are my answers to the rest of Thursdee's questions.

2. We were supposed to place 100,000 pesos in BPI Family's Plan Ahead account. Have you heard of this? It indicated 4.5% monthly income but the money would be locked for 5 years. Is this a good investment?

BPI Family's Plan Ahead account is basically a five-year time deposit product that is also offered by other banks, albeit at different interest rates. Five-year time deposits are attractive to some investors because interest income from these accounts are tax-free (the 20% tax is waived by law); of course, the caveat is that you won't be able to use your money for five years, which is a considerable amount of time to give up access to capital for most people.

We see the following details about the product from BPI's website:

Now we see why you thought this investment would provide a "monthly income" of 4.5%, or 54% per year, a figure that's closer to what loan sharks charge than what actually exists in "formal" markets; 4.5% is actually a yearly and not a monthly rate. The label "monthly" just means interest will be paid to you every month, amounting to 0.375% of your investment, instead of every year. 

This practice of misleading depositors, inadvertently or not, actually borders on being unethical, not just for BPI but other banks as well; I just say "borders" because because the bank actually does say in its website that the rate is an annual rate, although in a not-so-obvious way.

That being said, it does not necessarily mean that Plan Ahead is a bad product. But try to shop around for better rates from other, similarly reputable banks. Or if you have no qualms about investing in rural banks and are willing to completely place your trust in the Philippine Deposit Insurance Corporation (which insures bank deposits of up to 500 thousand pesos), they you may consider investing in these five-year deposits, most of which feature rates that are twice as high as that offered by BPI and other commercial banks.

3. Can you tell me more about Treasury bills and bonds? Is it really risk-free. I read also from one of the websites I came about during my "research" that it provides higher yield than time deposit accounts. Should we invest our 100,000 here instead of BPI's five-year time deposit?

Treasury bills or T-bills are short-term (one year or less) debt instruments offered by the government to investors; it basically represents what the government borrows from the investing public. Treasury securities (including Treasury bonds which are long-term) are considered "risk-free" only in the sense that it's impossible for the government to not be able to pay what it owes; as a last resort, the government can always just print money to pay off its debt, but of course while devaluing the currency at the same time. So strictly, treasuries are not really completely risk free since what investors earn can actually lose purchasing power, most likely from inflation. Still, since they are regarded as safe investments, they offer the lowest possible returns among available investment instruments (remember the high risk, high return rule).

A bond is just a generic type of long-term debt instrument that is sold by the government (Treasury bonds) or corporations (corporate bonds). Corporate bonds are riskier than government securities because it's entirely possible for corporate issuers to default on their debt (since they don't have an option to print their own money), and thus provide higher returns than Treasury securities. The last time I checked, annual returns on corporate bonds are in the range of 5 to 6% per year, after tax.

Both T-bills and bonds are sold by most banks and other brokers, albeit at higher minimum required investment amounts than other investment instruments. But there are alternatives for retail investors like you and I. If you want a safe investment similar to T-bills, you can always just invest in a time deposit account, or even a money market fund (mutual or UITF) so you won't sacrifice liquidity (meaning you can always sell your holdings at no or low cost). If you're comfortable with the additional risk of bonds (which significantly less than what you'll get from investing in stocks), then you can just invest in bond funds.

I hope you're satisfied with my answers to your questions, Thursdee. Happy investing and good luck. :)

4 Simple Ways of being More Confident of Your Future Finances

A recent study in the United States reveals that specific financial decisions and behavior can help uplift an individual's or family's feelings of economic security, especially during financial crises and recessions. Based on the results of a survey of more than 9,000 respondents over a two-year period, behavior that revolve around financial planning and a more disciplined approach to debt and savings was found to foster a feeling of economic security and optimism about the future.

1. Save more, regularly. Among the survey respondents, 44% of those who saved the most from month to month described themselves as “very” or “extremely” optimistic about their future finances. And 40% of those having the highest savings balances expressed similar optimism. But even among those with the lowest savings balance, 57% of those who consistently put money into savings also expressed optimism about their financial future. These findings show that financial optimism does not depend on how much one has already accumulated in savings--rather, it’s the practice of saving, itself, that creates an emotional lift.

2. Pay off your short-term debt. Carrying too much credit card debt and personal loan balances can greatly reduce an individual's or family's optimism about their future finances. In the survey, only about 35% of survey participants said they feel “very” or “extremely” financially secure from month to month, and only about 34% expressed optimism for their financial future. But among those with high short-term debt, expressions of financial optimism went down to 20%. What’s more, those most concerned about their debt are more likely to feel financially “stretched” from month to month--and are the least likely to make saving and investing a priority.

3. Increase your savings-to-debt ratio. One of the most important results of the study is that an individual or family can have some debt and still feel financially secure--as long as they’re disciplined in their approach to savings and diligent in their payment of debt. The savings-to-debt ratio thus appears to be a very important contributor to feelings of financial optimism, since as one’s savings-to-debt ratio increases, feelings of financial security increase, and feelings of being financially “stretched” decrease.

4. Come up with--and stick to--a financial plan. The survey shows that individuals and families having a financial plan are more likely to have a high savings-to-debt ratio than those without a plan. And this is consistent across all incomes, indicating that a family earning $50,000 per year can achieve the same level of financial optimism and confidence as a family earning $100,000 per year or more--if it is managing money according to a sound financial plan. 45% of survey respondents with a financial plan reported feeling “very” or “extremely” secure financially, compared to 31% of respondents without a plan. Finally, persons having a financial plan expressed significantly more confidence in dealing with financial matters than those without a plan, and they reported greater confidence in their ability to retire comfortably.

The message is simple: save more, pay off your debt, and take control of your finances by living by a financial plan, even a simple one. Visiting Investor Juan regularly is a good first step, and we'll always be here to support you the moment you take your next.

10 Exercises: A Fitness Manual for Random Walkers (Part 1)

STUFF I LEARNED FROM Burton G. Malkiel's "A Random Walk Down Wall Street"

1. Cover Thyself with Protection

"Disraeli once wrote that 'patience is a necessary ingredient of genius.' It's also a key element in investing; you can't afford to pull your money out at the wrong time. You need staying power to increase your odds of earning attractive long-run returns. That's why it is so important for you to have noninvestment resources, such as medical and life insurance, to draw on should any emergency strike you or your family."

I have a friend whose family wealth was almost completely wiped out by hospital expenses when her father got terribly ill. Preparing for an unfortunate situation like this is perhaps the most important reason why we should take control of our finances as early as possible.

There are two simple ways of protecting our families from unforeseeable emergencies and disasters: setting up an emergency fund and getting insurance.

An oft-quoted rule of thumb for an emergency fund is six months to one year's worth of living expenses in safe and highly liquid assets like bank accounts and money market funds. If you are covered by medical or disability insurance, you can reduce the amount accordingly.

For insurance, just make sure that everyone in the family has some form of medical coverage, and that breadwinners are covered by basic term life insurance plans. Most employment compensation packages already include these benefits; some plans can even be extended to members of your immediate family at lower cost, so if you're employed you can verify the details of your coverage with your HR manager.

2. Know Your Investment Objectives

"Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. The decision is up to you. High investment rewards can be achieved only at the cost of substantial risk-taking. This has been one of the fundamental lessons of this book. So what's your sleeping point? Finding the answer to this question is one of the most important investment steps you must take."

In choosing among available investment alternatives, investors need to know (or decide) how much risk they can bear (or want to carry) since generally, riskier investments provide higher potential returns. We have already talked about this in several posts in the past, but Malkiel's ingenious use of the relationship between risk and losing sleep makes it worthy of another look. The table below, patterned after the one used in the book, presents the "sleeping points" of widely available investment instruments in the Philippines.

Sleeping Point	Type of Asset	Typical Return	Risk Level
Semicomatose state	Commercial bank accounts	up to 1%	No risk of losing what you put in. Deposits up to 500,000 pesos are guaranteed by the PDIC. Risk of losing purchasing power with inflation is high, though.
Long afternoon naps and sound night's sleep	Commercial bank time deposit accounts	2.5 to 4%	Same as above, but less inflation risk.
Sound night's sleep	Money market funds	3 to 4%	Very little risk, but the principal is not guaranteed.
An occasional dream or two, some possibly unpleasant	Corporate bonds, bond funds	5 to 7%	For individual bonds, very little risk if held to maturity. Moderate to substantial fluctuations can be expected in realized return if bonds are sold before maturity.
Nightmares not uncommon, but over the long run, well rested	Diversified portfolio of stocks, equity funds	9 to 15%	Moderate to substantial risk. In any one year, the actual return could be negative (loss of principal). A good inflation hedge over the long run.

3. Dodge Taxes Whenever You Can

"One of the best ways to obtain extra investment funds is to avoid taxes legally."

Unlike in the US where they have tax-exempt investment and savings plans, in the Philippines there's not much wiggle room to "avoid taxes legally." The best thing individual investors can do is include tax effects in estimating the returns of available investments.

Source of income	Tax rate
Interest on bank deposits and trust funds	5 years or more - Tax-exempt 4 to less than 5 years - 5% 3 to less than 4 years 12% Up to 3 years - 20%
Cash dividends	10%
Capital gains from sale of stocks	Not over 100,000 pesos - 5% More than 100,000 pesos - 10%
Capital gains from sale of real property	6%

Small business owners and self-employed individuals can actually deduct some expenses from their gross income, which can result in substantial tax savings. If you estimate savings to be greater than the fee charged by an auditor, you might as well get one to make sure your documents and books are in order.

4. Be Competitive; Let the Yield on Your Cash Reserve Keep Pace with Inflation

"As I've already pointed out, some ready assets are necessary for pending expenses, such as college tuition, possible emergencies, or even psychological support. Thus, you have a real dilemma. You know that if you keep your money in a savings bank and get, say, 1 percent interest in a year in which the inflation rate exceeds 1 percent, you will lose real purchasing power. In fact, the situation's even worse because the interest you get is subject to regular income taxes. So what's a small saver to do?"

In the Philippines, the best way to keep the purchasing power of your emergency fund more or less intact without sacrificing liquidity is by parking it in an inexpensive money market fund like BDO's Money Market UITF. It's cheap (it has no "load" or sales commission and the management fee is only 0.5% per year) and efficient: in the past 5 years, the fund has been able to generate an annual net return of 4.73% per year, outperforming other similar funds in the market and pretty much keeping pace with the annual inflation rate.

5. Investigate a Promenade through Bond Country

"Small wonder many investors view the bond as an unmentionable four-letter word."

A bond is a form of debt security, in which the issuer (also referred to as the seller or borrower) promises to pay the holder (also buyer, lender, or investor) periodic interest payments called "coupon" payments and pay the principal at a predetermined date called "maturity." A variety of bonds is widely available to both individual and institutional investors: Treasury bonds are those offered by the government and corporate bonds are ones which are issued by big, established enterprises.

Like stocks, bonds can also be publicly traded in financial markets like the Philippine Dealing Exchange or PDEx. Bond prices are primarily determined by prevailing interest rates: when interest rates rise, bond prices fall, and vice versa. This causes fluctuations in the price, and expected return, of bonds prior to maturity.

Bonds are still generally perceived as safer investments than stocks, even if bond holders are actually exposed to many different kinds of risk. There are two main reasons for relative safety: one, coupon payments are compulsary and take precedence over dividends; two, in case of bankruptcy, creditors get first dibs on the remaining assets of the firm. Since it's safer, a bond would typically provide a lower return than riskier assets like stocks.

If you're interested in buying bonds, you can check out the website of PDEx for outstanding issues and approach an authorized bond broker or dealer (usually any one of the more reputable commercial banks) to buy the bond that you're interested in. You can also approach you chosen broker if you want to subscribe to new issues.

An alternative to buying individual bonds is to invest in a bond fund like a bond UITF, which is invested in a portfolio of bonds and other fixed-income securities.


To be continued.

Dissecting East West Bank's Latest Public Offering

INVESTMENT SPOTLIGHT

PERSONAL FINANCE 101

Got this from yesterday's issue of the Philippine Daily Inquirer. Thanks to Sam for the heads up: you’re turning out be a very reliable partner in looking for the best investment deals out there.

Okay, so what's this? All we see is financial gobbledygook that seems to make little sense. Which is what I'm here for--to try to make sense of things like this, things that matter, things that we should understand.

1. What is it?

In a nutshell, what it is is debt. Yes, for whatever reason, East West Bank (EWB) needs additional financing, 1.5 billion pesos worth, and it decides to raise this by borrowing from you, the investing public.

2. 7.5% p.a.?

If ever you decide to get in on the action, you’ll receive 7.5% of your investment or principal every year (“p.a.” stands for per annum or per year) as interest. That means if you buy 1 million pesos of this “note” or “bond” (or lend EWB 1 million pesos, same banana), you’ll receive 75,000 pesos interest per year, or 37,500 pesos every six months.

3. Unsecured?

It means that this debt is not secured by collateral—which is an asset provided by the borrower that the lender can claim when the former is unable to pay its financial obligations on time, or not at all. Secured debt—or loans or debt with collateral—thus tend to be safer than the unsecured kind, and should feature a relatively lower interest rate. Housing loans, car loans, even pawning a piece of jewelry, are all examples of secured debt.

4. Subordinated notes?

This means as a creditor or lender of EWB, you’re not top honcho, some other creditor is more important than you, and you’ll have to wait in line in case the shit hits the fan and the firm becomes insolvent or unable to pay its debt obligations, or if it enters bankruptcy.


5. Lower Tier II Capital?

This one’s a bit trickier than the other features, and it’s specific to banks.

Banks have two levels of capital: Tier I and Tier II. Tier I consists of money from the pockets of the owners (equity capital), money from the bank’s operations (retained earnings), and some kinds of preferred stock. Tier II capital comes from everyone else, like the bank’s depositors and creditors. The qualifier “lower” just means you have a lower claim than the banks depositors, meaning they’ll get paid first in case the bank gets into financial trouble. But of course, as a creditor, you still have higher priority than the bank’s owners and preferred stockholders.

6. Due 2021?

This means the note will mature in 2021, some 11 years from now (if I count my years right); on that date, you’ll get back your entire principal as the note is retired or redeemed. So in all, if you buy 1 million pesos worth of the note and hold on to it until the due date, you’ll get a total of 11 x 75,000 pesos or 825,000 in interest payments and 1 million pesos lump sum at the end of 11 years.

7. Callable?

It means the issuer, EWB in this case, has an option to “call” or buy back the note anytime from 2016 until the note matures in 2021. Why the hell would EWB want to do that? Well, if interest rates fall in that period to a level below 7.5%, it’s to the borrower’s benefit to buy back the note and issue another one at a lower interest rate. So what’s in it for you, the lender? Why the hell would you want to buy something with a feature that benefits the issuer? Well, compared to similar notes without this call feature, EWB’s note should have a relatively higher interest rate. And if ever EWB does decide to exercise its option, it will pay you back a higher amount, something equal to the principal plus an extra called the call premium.

8. With Step-Up in 2016?

No, this has nothing to do with your favorite street dance movie (“If you wanna be with someone who doesn't appreciate what a good thing he's got that's 100% your business. I just thought you'd be smart enough to know you deserve better.”). What this feature means is that EWB promises to increase the interest rate from 7.5% starting 2016 up to 2021. The exact schedule and amount of the increases should be detailed by the selling agents. Sounds good, right? But remember, the bond is callable. So there’s a chance EWB will retire the debt even before the first round of interest rate increase.

9. Should you buy into the issue?

Well, Sam wouldn’t. She’s turned off by the 11-year tenor, the call feature, and the “low” interest rate (which is already net of taxes, according to one of the selling agents).

One other important factor that you should consider is the reputation of the issuer, East West Bank. Unlike other, bigger banks that are awash with depositors’ money, EWB has to rely on other financing sources. What are the chances that EWB will default? To answer that question, you’ll have to try to know the firm better, maybe take a look at its financials, if you can.

If you’re not too impressed by EWB, maybe you can just wait and park your money in a temporary vehicle like a 30-day time deposit, like what Sam did. I’m sure a better deal is just around the corner.

By the way, I almost forgot: if you're interested in buying the notes, you have to make up your mind soon because the deadline is tomorrow. Just contact any one of the two mentioned selling agents in the ad to subscribe.

4 Things You Need to Know Before You Invest Your Hard-earned Money (Part 1)

5-year relative historical prices of BDO UITFs

Image from Bloomberg.com

1. Your investment objectives

While in general, every investor should choose an investment vehicle that provides the biggest potential return for a given level of risk, an individual’s unique, personal circumstances and preferences define a more specific investment goal that would, in turn, lead to a specific mix of securities.

Traditionally, investors choose among the following four goals:

a) Stability of income
b) Growth in current income
c) Preservation of capital
d) Capital appreciation

These goals are by no means mutually exclusive, although the natural tradeoff between risk and return makes it difficult to achieve the four goals simultaneously.

Goals (a) and (c) involve more investments in safer instruments like bank deposits, treasury securities, and corporate bonds, which feature reliable periodic income (e.g. coupon or interest payments of bonds) or strong or guaranteed principal protection (e.g. PDIC insured bank deposits), or both. Meanwhile, goals (b) and (d) require higher exposure to risky securities like common stock and speculative investment vehicles. And because both (b) and (d) involve the possibility that you’ll lose a portion of your capital, the amount of money are you able and willing to lose will define which of these two pairs of goals you would prioritize.

The choice between income (either with coupons or dividends) and capital appreciation (or capital gains) will be defined by your need for cash flows and how long you can afford to part ways with your cash. It is important to settle this issue especially if you’re planning to invest in stocks: while some stocks do pay out dividends consistently (referred to as “income” stocks and are characterized by low price-to-earnings ratio), some only rarely pay dividends (if at all) and consistently reinvest their earnings to spur growth (referred to as “growth” stocks and are characterized by high price-to-earnings ratio).

2. Your liquidity requirements

Liquidity is the ease by which an asset can be turned to cash at or near the asset’s market value: for example, a bank deposit can easily be converted to cash with an ATM withdrawal or a check issue, while it might take some time, and substantial cost, to cash in investments in real estate or personal property.

It’s important to set aside a certain amount of funds in highly liquid vehicles like savings and/or checking accounts for daily purchases and emergency expenses. The problem is that if you invest too much in traditional liquid investments like bank deposits or money market funds, you’ll lose out on the higher returns provided by less liquid investment vehicles. That is why it is often advised that individuals set aside an amount equal to six months worth of salary or expenses as an “emergency fund,” and invest additional savings in better-yielding securities.

What many of us don’t realize is that bond and stock investments are actually also pretty liquid, with the continuing popularity and growth of “markets” where these securities are actively bought and sold (the Philippine Stock Exchange or PSE for stocks, and the Philippine Dealing and Exchange Corporation or PDEX for government securities and corporate bonds).


Click here for Part 2.

7 Ways of Recession-Proofing Your Life (Part 1)

Image from Morris Creative

Have you ever noticed how more and more difficult it has become to find empty tables at popular cafes around the metro? My friend and I experienced this as we were having coffee in one of the more popular cafés in Trinoma last week. We talked about how these places seem to be always filled to the rafters, which is a surprising sign that we Filipinos are not as hard up as we think we are.

But what if the forecast of some analysts about a stock market crash materializes and reaches our economic shores? What can you do to protect yourself from a financial crisis? Here is a list of ways to “recession-proof” your life.

1. Do “sideline” work and earn extra income.

My real life hero when it comes to managing personal and family finances is my mom, who was able to support a family with five children almost single-handedly. I still remember how she did sideline work like buying and selling jewelry, providing tutorial services, and accepting odd catering jobs to supplement her meager income as a pre-school teacher. The best way to protect yourself and your family from a financial downturn is by increasing your disposable income by exploiting every opportunity that comes your way; unfortunately the problem usually isn’t the dearth of such opportunities, but a combination of our laziness and our disgustingly low standard for contentment. If you need extra cash, for example, and you have a decent grasp of the English language, give me a buzz and I’ll hook you up with a friend who employs part-time writers for his search engine optimization business.

2. Build an emergency fund. 

Perhaps the most important thing that you should prepare for in a recession is the possibility of being laid-off or demoted. An emergency fund will ensure that you’ll have enough money for daily expenses until you get back on your feet. One popular rule of thumb for the fund amount is six months worth of your net income, invested in a principal-protected, liquid vehicle like bank deposits that are insured by the Philippine Deposit Insurance Corporation for up to 500,000 pesos.

3. Be debt-free.

High interest charges on some kinds of debt like credit card balances will only put additional strain on your already stretched finances. For example, a credit card balance of 100,000 pesos will cost you 3,500 pesos on interest alone; even if you pay the minimum required amount due religiously, it will take years or even decades to lower your balance to more manageable levels. The best way to avoid this credit card trap is to suck it in while it’s still early and pay significantly more than the minimum amount due.

Also avoid other kinds of debt, like car or housing loans, during a recession. Even if interest rates for these kinds of debt are significantly less (around 10% annual percentage rate or APR) than those for credit cards (around 42% APR), the significantly higher loan amounts translate to equally higher monthly payments. For example, if you decide to buy a brand new Honda City worth 750,000 pesos and borrow the amount for 5 years with a down payment of 20%, you’ll have to cough up close to 14,000 per month. Coincidentally, you’ll have to pay almost the same amount if you decide to buy a condominium worth 1.5 million pesos by getting a 30-year housing loan from Pag-Ibig. 14,000 pesos is a lot of money for most of us, high enough that having to pay the sum every month in a recession is tantamount to committing financial suicide.

Ya gotta love that new Honda City

Click here for Part 2.