The truth behind number tricks
A financial product is invisible and is created in the minds of the investors when it is described by the company selling it in its advertisements, or by the agent in her words. But the gap between what is said and what’s true is often wide—“invest Rs.5,000 per month and get Rs.4 lakh per month after 20 years”, or “earn over 11% yield on fixed deposit”. Often, people get trapped in these products only to realize later that what they have invested in makes little financial sense. Why do we get attracted to products that are in reality sub-optimal? Because of an attractive-looking number. Daniel Kahneman, in his book Thinking, fast and slow, writes: “We can be blind to the obvious, and we are also blind to our blindness.” There are multiple marketing tricks that play number games. Here are three recent examples with suggestions on how to look beyond the marketing pitch.
Pitch: Get a home loan at just 7.99% (or any loan below the base rate).
What it means:
If you have come across such an offer either on a hoarding or a social media platform, first thing you need to do is check for clauses. No bank lends below the base rate. Currently, the base rate for banks is 10-10.25%. This means that any loan that you avail from a bank will be either at this rate or above it. So, when you see a pitch for, say, a home loan below the base rate, it most likely means that the builder is subsidizing your rate and is taking the responsibility to pay the interest rate difference. Such a scheme usually works like this: The rate at which you get the loan is, say, 10.50% and you pay the equated monthly instalment (EMI) at this rate. The builder will calculate your EMI at 7.99%, and pay you the difference between the two, either once a quarter or every half year.
This is just another version of a builder offering a discount. With such schemes, you must remember that if the builder does not pay you, your EMI to the bank at 10.5% has to continue.
“Other than the lower interest rate pitch for, say, three or five years, some builders also offer to pay the entire interest component for a year. Sometimes what happens is that some builders tend to inflate per sq. ft charges and then offer interest reimbursement. Before you get into any such a deal, read the agreement carefully because such offers come with a number of clauses. Also, ask for a detailed illustration to understand how the money flow will work,” said Dilshad Billimoria, director, Dilzer Consultants Pvt. Ltd.
Non convertible debentures
Pitch: Get effective yield of 12.25%
What it means:
Non-convertible debentures (NCDs) come with a coupon rate—the annual interest paid out. This interest rate could be compounded quarterly, half-yearly, or annually as published. Coupon rate should not be confused with the advertised effective yield. The effective yield is calculated as if the compounding is done on an annual basis or where the payout is monthly, effective yield is shown as if returns earned are compounded monthly. “The best way to compare medium to long-term investment options is through normalizing all instruments to arrive at annualized compounding interest rates,” said Srikanth Meenakshi, founder and director, FundsIndia.com.
An effective yield is based on the assumption that you reinvest the interest on an instrument that yields the same rate. This is theoretical as it is unlikely that you will be able to do so. Products that give a fixed rate of return often focus more on advertising yield as yield numbers usually appear bigger. While yield looks higher than the coupon, it isn’t accurate for you; you will receive the payout as per the advertised coupon and you can achieve the yield only if that money is reinvested. This is the case even for fixed deposits, our next product.
Pitch: Get 10.39% yield on 36-month fixed deposit
What it means:
Whenever you come across a fixed deposit (FD) marketing pitch, check if the number being advertised is interest rate or yield. Also check whether the yield to maturity is compounded half-yearly or quarterly. Often, depositors get confused between yield and return. The interest rate on an FD is normally the return offered on the principal amount based on compounded interest. It doesn’t include any other factors. For instance, if you invest Rs.10,000 for three years, in the first year, at 9% quarterly compounded interest, you will get Rs.938 as interest. At the end of three years, the total interest you earn will be Rs.3,086. The calculation works in reverse for yield.
To know the yield on the interest that you will earn from FD, the total return earned on investment has to be divided by the number of invested years. In our example, divide the interest amount of Rs.3,086 by three (years), which comes to Rs.1,028.66. The percentage yield or the annualized effective yield is about 10.20%. Whether you consider an interest rate of 9% or an annualized effective yield of 10.20%, the absolute figure of Rs.3,086 remains the same.
So, a higher yield doesn’t necessarily mean a better deal. Chances of getting confused are more if a competing product shows returns in interest and not yield.
Mint Money Take
Don’t just go by the number displayed in a brochure or an advertisement because it doesn’t give the full picture. To get the real picture, you always have to go beyond the numbers presented. Before investing in a product, ask the right questions; don’t get fixated on the percentage that financial institutions and companies quote. Besides this, you should also have the ability to find the difference between nominal and real return. Always remember to factor in inflation and tax to find out your real return. Ensure that you do your calculations. If you are not able to do this on your own, take the help of a financial adviser or even use online financial calculators.