Challenge Pathway -Prep Book

INTERNATIONAL COLLEGE OF FINANCIAL PLANNING CHALLENGE PATHWAY PREP BOOK Approved courseware for the Certified Financial PlannerCM certification education programme in India\" Published by 'International College of Financial Planning Ltd.' \"Every effort has been made to avoid any errors or omission in this book. Inspite of this errors may creep in. Any mistake, error or discrepancy noted may be brought to our notice, which, shall be taken care of in the next printing. It is notified that neither the publisher nor the author or seller will be responsible for any damage or loss of action to anyone of any kind, in any manner, there from. No part of this book may be reproduced or copied in any form or by any means or reproduced on any disc, tape, perforated media or other information storage device, etc. without the written permission of the publisher. Breach of this condition is liable for legal action. All disputes are subject to Delhi jurisdiction only.\"

International College of Financial Planning - Challenge Pathway Prep Book Published by the International College of Financial Planning Ltd. © International College of Financial Planning Limited 2002 This subject material is issued by the International College of Financial Planning Ltd. on the understanding that: 1. International College of Financial Planning Ltd., its directors, author(s), or any other persons involved in the preparation of this publication expressly disclaim all and any contractual, tortuous, or other form of liability to any person (purchaser of this publication or not) in respect of the publication and any consequences arising from its use, including any omission made, by any person in reliance upon the whole or any part of the contents of this publication. 2. The International College of Financial Planning Ltd. expressly disclaims all and any liability to any person in respect of anything and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or partial, upon the whole or any part of the contents of this subject material. 3. No person should act on the basis of the material contained in the publication without considering and taking professional advice. 4. No correspondence will be entered into in relation to this publication by the distributors, publisher, editor(s)or author(s) or any other person on their behalf or otherwise. Author Sanjiv Bajaj CFPCM, MBA (Finance), International Certificate for Financial Advisors (CII – London) Revised By: Madhu Sinha CFPCM, CIWM Author (“Financial Planning A Ready Reckoner”. Easy strategies for all, Campus Director, International College of Financial Planning, Mumbai Former Director , FPSB India \"Unless otherwise stated, copyright and all intellectual property rights in all course material(s) provided, is the property of the College. Any copying, duplication of the course material either directly, and or indirectly for use other than for the purpose provided shall tantamount to infringement and shall be strongly defended and pursued, to the fullest extent permitted by law.\"

Table of Content Challenge Pathway Prep Book 1 - 588 1. Personal Financial Management (Global) 1 2. Personal Financial Management (India Specific) 30 3. Investment Planning and Asset Management (Global) 53 4. Investment Planning and Asset Management (India Specific) 144 5. Regulatory Environment & Compliances (Global) 229 6. Regulatory Environment & Compliances (India Specific) 259 7. Retirement Planning (Global) 259 8. Retirement Planning (India Specific) 339 9. Taxation (Global) 373 10. Taxation (India Specific) 399

11. Risk Management & Insurance Planning (Global & India Specific) 497 12. Estate Planning (Global) 545 13. Estate Planning (India Specific) 566

Personal Financial Situation Many individuals do not invest much time in reviewing or managing their personal financial situation. This becomes evident as soon as the financial professional evaluates a client’s financial status for the first time. In many cases (although certainly not all), clients are unaware of the exact state of their financial lives. Staying on top of personal finances takes time, a moderate amount of knowledge, organization, and a willingness to explore those areas that the client may not have understood or wanted to address. Understanding the individual’s current financial situation is the first step in any financial advisory interaction. To do this, you will need to review and evaluate financial documents, including those that show assets and liabilities. Situations are not always straightforward, so the financial professional will have to determine whether there are any issues related to the client’s existing assets and liabilities. Timing can be crucial. Determining whether the client is living within his or her financial means is an overall goal for the financial professional. Living Within Financial Means The best way to determine the degree to which clients are (or are not) living within their financial means is to compile and evaluate updated information about their assets, liabilities and cash flow. Gathering client data and general information are some of the main items required when approaching financial management. To this, we can add identifying and quantifying goals. The focus of any financial management strategy will be on helping the client achieve goals. It will be helpful for the financial professional and client to have a shared understanding of the client’s current financial situation, especially of any areas that seem to be causing problems. International College of Financial Planning – Challenge Pathway Prep Book Page 1

These financial “hot spots” should be among the first areas to tackle in any interaction. It may be that the rest of the process will have to wait while the financial professional and client work through addressing bigger problem areas. Key Terms A statement of financial position is essentially a picture of the client’s finances at a specific point in time. Information within the financial statement can change substantially year-by-year. Reviewing the statements helps the financial professional and client determine how well the client is on the path to achieving financial objectives. Over time, the statement of financial position will identify whether a client’s net worth remains the same, increases or decreases. Assets There are three broad categories of assets: 1. Liquid assets (cash/cash equivalents), 2. Invested assets and 3. Use assets. -Use assets (or lifestyle assets) include just about any asset that the owner does not plan to sell. This category normally includes a person’s house, cars, boats and personal property, such as furniture, clothing, jewellery, artwork and other assets that are used by the owner with no current intent to sell. Liability The liability side of the balance sheet lists current debts. Items in this category might include any outstanding balances on a mortgage note, auto note or credit card statement. Liabilities often are categorized as either short term or long term (lasting longer than one year). A balance sheet lists the outstanding balance for each liability as of the date of the statement. International College of Financial Planning – Challenge Pathway Prep Book Page 2

The difference between assets and liabilities is net worth. The net worth statement is also known as a balance sheet or statement of financial position. Simply, it is a record of a person’s assets and Remember how an individual’s net worth is calculated: Net Worth = Assets – Liabilities Six Steps in Financial Management Process Page 3 1. Establishing and defining the client-advisor relationship 2. Gathering client data, including goals 3. Analyzing and evaluating the client’s financial status 4. Developing and presenting recommendations and alternatives 5. Implementing the recommendations 6. Reviewing and monitoring progress toward goal-achievement Category of Assets 1. Liquid assets (cash/cash equivalents) 2. Invested assets 3. Use assets International College of Financial Planning – Challenge Pathway Prep Book

The primary factor differentiating the two is the intended application or use of the asset. A use asset is one that the owner does not plan to sell. A piece of fine art is an example. If it is being held to eventually sell, it’s best categorized as an invested asset. If it is being held to enjoy, but not to sell, it most likely should be considered a use asset. Time Value of Money The value of a unit of currency today is almost always worth more than the future value. Investments made today are expected to grow at a measurable rate. It is also true that inflation would take a sizable bite out of that amount, but the illustration serves to highlight the impact of compounding. The financial professional must understand that the value of money changes over time, and that this will affect his or her recommendations to clients. What is the Time Value of Money? The time value of money is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future. This is true because money that you have right now can be invested and earn a return, thus creating a larger amount of money in the future. (Also, with future money, there is the additional risk that the money may never actually be received, for one reason or another). The time value of money is sometimes referred to as the net present value (NPV) of money. How the Time Value of Money Works A simple example can be used to show the time value of money. Assume that someone offers to pay you one of two ways for some work you are doing for them: They will either pay you $1,000 now or $1,100 one year from now. Which pay option should you take? It depends on what kind of investment return you can earn on the money at the present time. Since $1,100 is 110% of $1,000, then if you believe you can make more International College of Financial Planning – Challenge Pathway Prep Book Page 4

than a 10% return on the money by investing it over the next year, you should opt to take the $1,000 now. On the other hand, if you don’t think you could earn more than 9% in the next year by investing the money, then you should take the future payment of $1,100 – as long as you trust the person to pay you then. Time Value and Purchasing Power The time value of money is also related to the concepts of inflation and purchasing power. Both factors need to be taken into consideration along with whatever rate of return may be realized by investing the money. Why is this important? Because inflation constantly erodes the value, and therefore the purchasing power, of money. It is best exemplified by the prices of commodities such as gas or food. If, for example, you were given a certificate for $100 of free gasoline in 1990, you could have bought a lot more gallons of gas than you could have if you were given $100 of free gas a decade later. Components of TVM The key components are as mentioned below – 1. Interest/Discount Rate (i)– It’s the rate of discounting or compounding that we apply to an amount of money to calculate its present or future value. 2. Time Periods (n) – It refers to the whole number of time periods for which we want to calculate the present or future value of a sum. These time periods can be annually, semi-annually, quarterly, monthly, weekly, etc. 3. Present value (PV)– The amount of money that we obtain by applying a discounting rate on the future value of any cash flow. 4. Future value (FV)– The amount of money that we obtain by applying a compounding rate on the present value of any cash flow. International College of Financial Planning – Challenge Pathway Prep Book Page 5

5. Instalments (PMT)– Instalments represent payments to be paid periodically or received during each period. The value is positive when payments have been received and become negative when payments are made. 1. Present Value (PV) The present value is known as the current value of a sum of money that we will receive in the future. We have mentioned that the purchasing power of money reduces over time. The formula of PV accounts for this reduction by applying a discounting rate to the sum that we will receive in the future. Due to the use of the discounting rate, the process of calculating the present value of a sum of money is also known as discounting a sum of money. The PV of a sum of money can be used to determine the current value of projected cash flow from a bond, an annuity, a loan, or any such instance where you are supposed to receive money from a third party in the future and you want to know exactly how much that money will be worth today. It is given by the following formula – PV = FV / (1 + i)^n Here, we require three things to calculate the present value – 1. What is the value of the sum we will receive in the future? (FV); 2. What is the rate of discounting at which the purchasing power of the money will fall? (i); and 3. After how many years will we receive the concerned sum of money? (n). 2. Future Value (FV) As the name goes, the FV denotes the value of a sum of money at some date in the future. This calculation is useful for investors and businesses who want to know the future value of their potential investments to make a good investment decision. International College of Financial Planning – Challenge Pathway Prep Book Page 6

The formula for FV is given by – FV = PV (1+i)n This formula requires only three things to give us a future value – 1. What amount of money do we have right now? (PV); 2. What is the assumed interest rate at which it will grow? (i); and 3. After how many years will we need the money? (n) Solving Time Value of Money Problems International College of Financial Planning – Challenge Pathway Prep Book Page 7

Rate Assumptions Good investment recommendations involve much more than just potential return calculations, but most people do invest to achieve as high a rate of return as possible while remaining consistent with their risk tolerance and financial goals. It’s extremely important, even now, for the financial professional to understand this principle: past results are no guarantee of future returns! You should realize the significance of understanding both historic and potential future rates of return and inflation rates for various investment alternatives. The important factor to remember is the deviation, or spread, between assumed rates of return and inflation. For example, an assumption of a six percent rate of return with a four percent inflation rate yields a spread (or deviation) of just under two percent. Calculate Required Rate of Return In the context of financial advice, goals generally require funding. Funding, for most clients, includes saving and investing. Saving is for short-term goals where the primary objective is 100 percent safety (i.e., liquidity) of deposited funds. This means there is little, if any, place for the usual variability of investments. Investing, on the other hand, is for longer-term goals where variability is not the overarching concern (this is not to say variability is of no concern, just that it is not the primary concern). Calculating a required rate of return is simple. First, determine how much money a client needs to meet a goal, then how much time remains between the present and when the funds will be needed, then how much has already been accumulated and what will be available for additional investment(s), and then solve for the required rate of return. As an example, assume your client needs $100,000 in 10 years for a goal. The client has already accumulated $20,000 and is able to make additional annual investments of $5,000. International College of Financial Planning – Challenge Pathway Prep Book Page 8

The calculator keystrokes to determine the rate of return are: (P/Y = 1, Mode = End) 1. 10 N 2. 20,000 (+/-) PV 3. 5,000 (+/-) PMT 4. 100,000 FV 5. I/YR = 5.73169 Present Value of a Single Sum The present value of a single sum is the present worth of a sum to be received in the future that has been discounted for a given number of periods and at a given interest rate. Present value is determined by reversing the compounding process, also known as discounting. The three known variables used to compute a present value of a single sum are 1. the future value, 2. the discount rate, and 3. the number of discounting periods. Present Value of an Annuity A client expects to receive a payment of $1,000 at the end of each of the next three years. If opportunity costs are eight percent annually, what is the annuity worth today? Mode = End P/Y = 1 International College of Financial Planning – Challenge Pathway Prep Book Page 9

1. N = 3 2. I/Y = 8 3. PMT = 1,000 4. FV = 0 5. CPT PV = - 2,577.09699 Number of Compounding Periods A client has $1,000 to invest, and he or she wants to accumulate $3,670. If the client can earn eight percent annual interest on investments, how many years will it take the client to achieve the goal? Mode = End P/Y = 1 1. I/Y = 8 2. PV = -1,000 3. PMT = 0 International College of Financial Planning – Challenge Pathway Prep Book Page 10

4. FV = 3,670 5. CPT N = 16.89415 Years Interest Rate per Compounding Period A client has $1,000 to invest, and he or she wants to accumulate $1,470 in five years. What annual rate of interest must the client earn to achieve the goal? Mode = End P/Y = 1 1. N = 5 2. PV = -1,000 3. PMT = 0 4. FV = 1,470 5. CPT I/Y = 8.00988 International College of Financial Planning – Challenge Pathway Prep Book Page 11

Present Value Annuity Due (PVAD) of a Serial Payment Assume Otto wants to retire 20 years from now with the inflation-adjusted equivalent of $50,000 additional annual income (above benefits provided by a government or employer pension). Payments at the beginning of each year. As Otto and the financial professional discuss his retirement, the two agree to plan for 30 years of inflation-adjusted income in retirement. Annual inflation is stable at 3.5 percent, and Otto’s portfolio is earning eight percent annualized. How much money will Otto need if he wants the entire amount in place at the beginning of his retirement? The 3 steps for the calculations for retirement planning and education planning are the same -The 3 steps for the calculations for retirement planning and education planning are the same to determine a lump sum required today. -We use education planning in insurance planning when we want to know a lump sum amount T= 0 to fund future education. -We use education planning in basic family financial planning for determining a yearly or monthly savings target Step 1. Inflate the current cash flow amount or expense for the number of years until required (start of retirement or university i.e. in the future) to determine the first year’s cash flow need. This step uses the rate of inflation only. Step 2. Calculate the amount needed at the beginning of retirement or university (i.e., not today) to fund the inflation-adjusted cash flow required for the client to maintain purchasing power throughout the anticipated retirement period. This step uses the real (i.e., inflation-adjusted) rate of return, and is almost always calculated as an annuity due (i.e. in BGN mode). International College of Financial Planning – Challenge Pathway Prep Book Page 12

Step 3. The third step can either solve for a lump sum amount or annual payments needed today to accumulate the retirement fund. As this step only involves the investment return, we will use the investment, or discount rate. Cash Flow Demands & Conflicts A cash flow statement identifies a person’s financial transactions over a period of time. Rather than give a picture of assets, liabilities and net worth it shows the inflows and outflows of cash, sources of income, spending, saving and investing patterns. Inflows include all the money an individual receives from all sources. Depending on the individual’s situation, the category can include items such as: -Salaries and wages from employment -Income from self-employment -Interest and dividend income -Rental income -Pension payments -Tax refunds -Withdrawals from savings accounts -Proceeds from liquidation of assets -Income from grants, trusts, gifts, allowances, etc. Notice that dividends are shown on the inflow section. This is true even when they are immediately reinvested. When this happens, to support clarity and transparency, they will be reflected as both an inflow and an outflow. Outflows can be identified as fixed or variable. Fixed outflows are those that typically remain the same (or nearly so) each accounting period. Variable outflows are those that are more flexible, and the individual has more control over the timing and amount of payments. Examples of Fixed Outflows: -Housing payments International College of Financial Planning – Challenge Pathway Prep Book Page 13

-Insurance premiums -Loans, credit card and other long-term debt repayments Examples of Variable Outflows -Healthcare expenses -Child care expenses -Food & Gifts and charitable contributions -Utilities, maintenance and upkeep housing expenses -Holidays -Miscellaneous expenses (e.g., postage, fuel, education, periodicals, etc.) -Transport (e.g. cost of getting to/from work – maintaining, registering and insuring a motor vehicle as well as parking and fuel costs and/or public transport costs) Net inflow is similar in concept to net worth but focused on cash flows. Add all inflows together and all outflows together. The resulting amount may be positive or negative, or zero. The net inflow amount does not necessarily equal money available for use in savings or investments, or for other discretionary purposes, because individuals may not fully disclose all necessary information. However, once the financial professional can obtain most, or all, relevant information, he or she should be able to compile a reasonably good picture of the client’s financial state. Often, there are conflicting demands on a person’s available cash flow, and part of good financial advice involves resolving those conflicts. After identifying current cash flow demands, the financial professional will be able to identify those that conflict with each other. From there, the financial professional, working closely with the client, needs to evaluate options. The primary tool for this evaluation is a clear articulation of the client’s goals. Once identified and well-stated (which includes assigning time horizons and cost expectations), goals must be prioritized. International College of Financial Planning – Challenge Pathway Prep Book Page 14

Some cash flow conflicts can be faced by combining several strategies. Debt could be reduced. Income could be increased. Debt payments could be restructured. Options such as these can help address conflicting demands for limited resources. Often though, potential choices will be more nuanced, necessitating careful evaluation and prioritization of goals. What should a client do in a situation with two goals, but with only enough time and money to fund one of them? In situations like this, if the client cannot delay or otherwise fund the goal, he or she may need to modify or eliminate it. The financial professional does not get to decide which goal to modify or eliminate. The financial professional can only provide guidance to the client, who must make the choice to resolve the conflicting cash flow demands. The dividend would be listed as an inflow as income. It would also be listed as an outflow under investments. The cash flow statement should show both aspects of the transaction. After identifying current cash flow demands, the financial professional will be able to identify those that conflict. From there, the financial professional, working closely with the client, needs to evaluate options. The primary tool for this evaluation is a clear articulation of the client’s goals. Once identified and well-stated (which includes assigning time horizons and cost expectations), goals must be prioritized. Goal prioritization usually involves various levels of compromise. Budget & Emergency Fund A budget is a tool for evaluating spending patterns. It can be used to estimate income and expenses to create a financial roadmap for day-to-day living. Clients who use a budget generally have fewer financial problems than ones who simply spend as they go. One of the realities of life is that events do not always happen as planned. People lose jobs, get sick, have accidents or have major appliances that break-down and need to be replaced. All sorts of things, planned and unplanned, can enter a person’s life and require a significant financial outlay. International College of Financial Planning – Challenge Pathway Prep Book Page 15

Such outlays can side-line the best intentions to follow a budget and may seriously impact future goal achievement. Good financial preparation, therefore, will include development and maintenance of an emergency fund. Budget Creation and Evaluation Budgeting is the process of estimating and then tracking where money is spent each month to develop a clearer picture of where the client’s money is going. Clients can easily identify their fixed expenses and major variable expenses, but sometimes find that they don’t have nearly as much money at the end of the month that they think they should have. This is often because clients are unaware of where they are spending their money. Some advantages of working through the budgeting process are: 1. Identifying unnecessary expenses 2. Avoiding the use of credit cards for every day expenses 3. Identifying areas of family conflict over spending priorities 4. Providing an opportunity for families to discuss spending priorities 5. Increasing the likelihood of achieving financial goals Some disadvantages of working through the budgeting process are: 1. The process can be laborious. 2. Clients may be embarrassed by some of their spending habits and not keep accurate records. 3. People often do not like the structured approach of tracking inflows and outflows. International College of Financial Planning – Challenge Pathway Prep Book Page 16

Steps of Budgeting Process 1. The first step in the budgeting process is to estimate income from all sources that is available to meet monthly expenses. 2. The next step is to estimate expenses, both fixed and variable. At this point it is up to the clients to track expenses. 3. A good financial professional will periodically check in during this time frame to determine how well the client is doing with the work. 4. Encouraging clients to stay engaged in the process is important at this point. When the established time frame is over, the financial professional should sit down with the client and review the results. 5. Look for opportunities to eliminate unnecessary spending to help the client be more efficient while still maintaining a reasonable lifestyle. 6. Finally, the expense categories should be shown as a percentage of net income so that comparisons can be made over time. International College of Financial Planning – Challenge Pathway Prep Book Page 17

Emergency Fund and Funding Vehicles An emergency fund, as the name implies, is money put aside to cover financial emergencies. Building an emergency fund is one of the core financial activities the financial professional should address with clients. Life often produces hurdles or roadblocks, and a lack of available funds can worsen the results. An emergency fund typically focuses on two types of emergencies: International College of Financial Planning – Challenge Pathway Prep Book Page 18

1. loss of income and loss or 2. damage of property. Loss of Income Financial plans are usually built around an ongoing stream of income. The focus is on goal- achievement, but the primary tool is proper management of financial resources. Those resources include income, and the loss of income can do serious damage to any goal-achievement action plan. A client might lose income for several reasons. People generally expect to remain healthy and working, but sometimes an illness or an accident can change those expectations. Job loss is another reason a client might lose income. Step 1 : Determine how much income a client needs on a monthly basis. This may or may not be equal to the client’s normal employment income. a) Total the monthly expenses b) Subtract the amounts normally required for work (e.g., transportation) c) Subtract additional sources of income and benefits d) Calculate the gap between income resources and remaining need Step 2 : Multiply the amount from step one by the number of months the individual anticipates being without income Step 3 : Subtract available financial resources from the amount in step two. a) Resources may include cash/liquid assets, insurance, government benefits, gifts from family, etc. The result of step three is the amount of emergency fund needed to cover this need. International College of Financial Planning – Challenge Pathway Prep Book Page 19

Loss or Damage to Property When considering potential property loss (and we will include adverse legal action in this category), insurance coverage is probably the best financial tool to use for protection. We will discuss in the Risk Management and Insurance module, the right types and amounts of coverage. The financial professional should estimate the real possibility of property losses that will not be covered by insurance or other resources. As is true of designing an insurance portfolio, the idea is not to save enough money to protect against all possible losses from all possible causes. Rather, it is to save an amount that provides reasonable coverage. Reasonableness is the key to determining how much money should be used for emergency funds. As is true with insurance, it is important to have enough coverage to reasonably protect against potentially devastating losses. The definition of “reasonable” is a topic for discussion between financial professional and client. Appropriate Funding Vehicle Cash is the short answer as to where emergency funds should be held. A bank checking or savings account can make a good choice, although interest earned is usually quite low. Money market or guaranteed collective investments such as mutual funds can be a reasonable option and may produce some earnings. A combination of cash and a series of laddered bonds or bank certificates might work, depending on the amount of money involved. The financial professional could recommend putting (for example) one fourth or one third of the money into cash or cash equivalents. The remainder of the money can be used to purchase a series of bonds. Financial professionals should not consider the option of investing the funds in equities (either individual securities or pooled/mutual funds). Equities can have good earnings; however, the value of International College of Financial Planning – Challenge Pathway Prep Book Page 20

equities fluctuates, sometime substantially. The danger is that an emergency will arise at a time when the price per share is substantially below the amount originally invested. Building Cash Reserves We have covered the need to maintain cash or near-cash funds, as well as the need to be somewhat cautious as to the amount held. Now, we need to look at strategies for building various cash accounts. In some cases, individuals have excessive liquidity (e.g., much of their money is held in bank deposits). Most times, though, people do not have enough money in the necessary cash holding accounts and need to have a plan to build up the accounts. For the average client who does not have adequate cash on hand, the plan to build a cash reserve will depend on available discretionary income, assets that can easily be liquidated (without loss of value), and the ability to balance this with other goals. Compromise and trade-offs are common themes for this activity. If the client does not have much or any discretionary income, the most important activity becomes realigning income and debt to create a discretionary stream of income. Diff Between Proforma Budget & Regular Budget A pro forma budget looks into the future to estimate cash flows. It is normally based on past actual budgets but may also include items that are anticipated at a future date. A regular budget identifies, and is built from, actual cash flows. Debt & Financing Alternatives Debt is not inherently bad. In fact, debt, used properly, can help individuals, organizations, investors, governments and others accomplish their objectives. On a grand scale, countries use debt (sovereign debt – bonds and notes) to keep the government running. International College of Financial Planning – Challenge Pathway Prep Book Page 21

Companies do the same thing. It makes sense that individuals also would find beneficial uses for debt. Unfortunately, the misuse of debt – by individuals or other entities – can be financially devastating. On an individual level, clients may choose to use debt wisely or unwisely. One result of this is that two households with similar income and assets may have widely different financial well-being if one has used debt wisely and the other has not. Credit Use and Potential Problems When something is bought on credit, the purchaser incurs a debt by borrowing the purchase price. Credit is a financial tool, and like any tool it can be used correctly or incorrectly. A person may have many reasons to use credit. Usually, an individual uses credit because money is not available to buy something. The “something” may be a discretionary purchase, an emergency purchase (e.g., replacing a blown-out car tire), a large financial transaction (e.g., purchasing a major appliance), or other similar items. Debt payments decrease cash flow and restrict funds that could otherwise be available for other purposes. For this reason, debt is best used if possible, to purchase assets that build equity, such as real estate. Excess use of consumer debt should generally be avoided, because it is not often used to build equity or any long-lasting financial value. Qualifying for Credit: The 5 C’s Most lenders consider the following areas when evaluating a potential borrower: 1. Character, or apparent honesty and reliability. A credit record shows how well a person has followed through with previous financial responsibilities. Personal experience with a lender can also be a consideration. 2. Capital, or net worth. The lender is looking for positive net worth. International College of Financial Planning – Challenge Pathway Prep Book Page 22

3. Capacity, or how much income is available for debt service. 4. Collateral, or assets that can be used to secure the debt. When necessary, a lender will check to see what assets are available to be sold in the event of a loan default. 5. Conditions, or the general economic environment. Currently, many lenders are following a tight money policy. This means they are requiring individuals to satisfy more rigorous qualification requirements. It also may mean that credit, if extended, will be more expensive. Credit Score A person’s credit score is not based on any one piece of information, but how the different pieces interact. Factors include: 1. Whether account payments are current 2. Amounts currently owed 3. Length of time accounts have been open 4. Types of credit being used 5. Amount of credit being used, compared with total available credit. 6. Credit application activity Of greatest importance is a person’s repayment history and total amount of credit being used. The two general types of credit are installment and revolving. The former is almost always amortizing or reducing loans over a finite period while the latter can be either on a reducing or a non-reducing basis. Mortgages and Other Instalment Loans Instalment loans generally come with finite repayment periods (e.g., up to 30 years in some cases). Typical uses of instalment debt include purchasing a car, home, large appliances, etc. Sometimes, an instalment loan can simply be used to provide ready access to cash. The term of the loan depends on the purpose of the loan finance. International College of Financial Planning – Challenge Pathway Prep Book Page 23

A home mortgage is probably the most widely used type of long-term instalment loan. With a mortgage, the borrower (mortgagor) gives the lender (mortgagee) a lien on property as security for the repayment of the mortgage. A lien is the legal right to repossess the property (i.e., collateral) in the event the borrower defaults on the loan. When the mortgagor repays the loan, the mortgagee removes the lien. People most often mortgage real estate, but other property, such as motor vehicles, can also be mortgaged. Interest rates on any loan may either be fixed or variable. The interest rate on a fixed-rate loan does not change either throughout the life of the loan or for a specified period during the loan. Normally, payments on a fixed rate loan do not change but payments could be subject to change if the interest rate is variable to ensure the loan is repaid within the original term. By making regular payments on the mortgage, the borrower is said to be “amortizing” the mortgage. An amortization schedule shows how much interest and principal the mortgagor repays with each monthly payment. The amount of each payment (interest and principal) typically varies over time, with more interest paid earlier in the loan and more principal paid as the loan matures. Periodic Payment or Receipt A client wants to purchase an automobile for $10,000 and can finance the purchase at 12 percent, compounded annually, for four years. What payment will be required at the end of each of the four years? International College of Financial Planning – Challenge Pathway Prep Book Page 24

Financial Management Strategies The goal of strategic optimization is to devise plans that are as effective and functional as possible, to help a client reach his or her financial goals. In this case, the focus is on financial management, but the principle of strategic optimization will remain true for all financial advisory purposes. Developing and Optimizing Financial Management Strategies The first step to developing an effective financial management strategy is to analyze the client’s current situation. The tools discussed earlier – cash flow statement, budget and, to some extent, the statement of financial position – can be put to good use in this exercise. Once the financial professional has a clear idea of a client’s current picture, the financial professional can begin formulating a financial management strategy. To develop a strategy, we will consider four areas: 1. Cash flow (budget) 2. Cash on hand, including emergency funds 3. Anticipated needs for cash 4. Desired levels of cash accumulation Cash flow You can evaluate a person’s cash flow situation by considering the answers to two questions: 1. Does the person have more money flowing in than flowing out? 2. If the answer to question 1 is “no”, is there a way to remedy the situation? Excess cash outflows can be the result of several things. Some could include: -Significant additional expenses, such as an illness or major home repairs -Job loss or other income reduction -Variable interest-rate increase on a mortgage or other loan International College of Financial Planning – Challenge Pathway Prep Book Page 25

-Unanticipated increases in insurance costs, taxes or similar -Excessive spending patterns -Credit purchases with a resulting increase in debt service -Divorce, separation or death of a spouse or partner -Inflationary increases for a person on a fixed income -Other issues such as a gambling addiction or alcohol or substance abuse Bankruptcy Not all territories have bankruptcy laws. Where they exist, bankruptcy laws generally allow for one of two methods to address severe debt situations. The most significant form of bankruptcy is debt forgiveness. That is, after the bankruptcy petition is approved, debts are eliminated or liquidated. In some jurisdictions, not all debt qualifies for liquidation. For example, in the United States, child support payments cannot be eliminated through bankruptcy, nor can college student loans. In all cases, bankruptcy appears on a person’s credit report and can continue to adversely affect a client’s credit rating even beyond the period of the bankruptcy if the bankruptcy stays on the record. Many creditors prefer debt restructuring to bankruptcy. Rather than eliminate debts, creditors agree to accept lower payments, either by extending the repayment term, forgiving part of the debt, or by lowering interest rates. These may also be used in combination. The big upside for debt restructuring is that it does not normally require giving up assets. In return for the promise to repay the debt, the client gets to keep all, or most, assets. Businesses also periodically use this form of restructuring. International College of Financial Planning – Challenge Pathway Prep Book Page 26

Bankruptcy should never be considered as the first, best option. However, after a client has explored all reasonable alternatives, bankruptcy, if an option, can improve a client’s financial situation. Other Forms of Eliminating Debt or Reducing Payments Strategies to raise money to pay off other debt. For example: -Can an expensive home be sold in favor of a less expensive option, perhaps even shifting from home ownership to renting? -Or could the home be rented to a tenant while a smaller, cheaper property is rented for owner occupation? -If there is a vacation home or other property, can it be sold to raise funds? -With more than one car, can one be sold, and the money used to reduce debt? -Can an expensive car be sold and some of the money be used to purchase a less expensive model and pay down debt? -Is there a piece of art or other collectible that might be sold to pay down debt? Mortgage or Other Long-Term Debt Before looking at the other side of the equation – increasing income – we should address a frequent question. Does it always make sense to eliminate a mortgage or other long-term debt? Not necessarily. Let’s assume that the client is making all payments on a timely basis, has some level of discretionary income and savings, and is generally in reasonably good financial condition. How do we determine whether such a client should shift money into paying off a mortgage? A financial professional can look at this question in one of two ways: 1. the first way addresses the desire for security, and 2. the second way addresses a client’s overall financial picture. International College of Financial Planning – Challenge Pathway Prep Book Page 27

Increasing Income Sometimes, reducing debt is not the only solution. In fact, there may be times when, short of bankruptcy, debt payments cannot be reduced. An alternative, and additional option, is increasing income. While this may be difficult, it is sometimes possible to find additional income sources. Here are a few possibilities for increasing income: 1. Ask for a raise at work or ask for more responsibility that might provide a higher salary. 2. If doing shift work, ask to work an additional shift. 3. Find a second job, possibly part-time, to supplement income. 4. Get a new job with a higher salary. 5. Shift investments from a growth focus to an income focus. This must be done with care, as it may negatively impact other long-term goal achievement and generate unwanted tax consequences. 6. Income-producing investments include real estate, bonds and dividend-paying equities. 7. Complete an education program to qualify for a better paying job, or a higher salary from the current job. (Note: An issue with this option is that education usually costs money, and that doesn’t help solve the problem of not enough net inflow. However, there may be low or no- cost options that could be helpful, such as on-the-job training and some government-sponsored programs). 8. Rent out a room in the home. 9. Start a new or part-time business (i.e., become an entrepreneur). Saving People in some territories are known for saving money, while those in other territories are known for spending more and saving less. Local culture, along with the economic environment, can have a lot to do with whether someone is considered a saver. People often want to know the recommended amount of income to save. International College of Financial Planning – Challenge Pathway Prep Book Page 28

The answer, of course, depends on the individual, but we can identify a reasonable rule of thumb. For decades, people have been encouraged to save 10 percent of their income. There is nothing particularly magical about 10 percent. It is a good starting point for many and gets people in the saving habit. The real answer to the question of how much to save is, “how much do you need to accumulate within what amount of time?” This answer will more specifically determine the amount of savings needed. The Impact of Changes We have demonstrated that changes to inflows or outflows affect overall cash flow management. Sometimes these changes are subtle and small. Other times, the changes can be substantial. When life changes money is in motion. See the attached for examples of the life transitions that a client may be experiencing now or expect to experience in the near future. Getting from Here to There Sometimes goals are complex, and the client’s resources may be limited. We will look at such a situation shortly. Before we do that, let’s explore the process of determining and following a plan of action. Even in a simple situation, the client may need some direction about how to implement the plan of action to achieve a goal. International College of Financial Planning – Challenge Pathway Prep Book Page 29

Cash Management/Liquid Investment Products in India Bank Savings Accounts and Time Deposits India has a robust system of banks that allow depositors to park monies for various timeframes- ranging from 7 days to 10 years. While these are time deposits and have a fixed tenure, the bank also gives some basic rate of interest for funds lying idle in the bank. This is generally in the range of 3-5% p.a. For time deposits or Fixed deposits (FDs as they are popularly known), the interest rate varies with the periodicity- most banks offer rates currently between 5%- 8% p.a. depending upon the time period of blocking the funds with them. The deposit can also be withdrawn before time. Most banks do not charge pre-withdrawal penalty but do reduce the interest rate for the proportionate time period the funds are maintained with them. There is also a tax saving FD under section 80C which has a limit of Rs. 1.5 lacs and a lock-in of 5 years Recurring Deposits Regular salaried individuals, retirees receiving pensions, parents of minor children, small savers also prefer an option of depositing monies in the bank called “Recurring deposits” or RDs as they are popularly known. Here, the depositor does not have to make an upfront payment of the entire amount for his investment. He can break it down over most or the entire tenure of his deposit term and make payments weekly/Monthly/ quarterly. Interest generally compounds quarterly and the tenure can vary from 6 months to 10 years. Interest rate is generally around the same as FDs - between 5%-8% p.a. International College of Financial Planning – Challenge Pathway Prep Book Page 30

Corporate Deposit and Post Office Term Deposit Corporate Deposits Some corporates In India also raise funds from the retail space by floating public deposits directly. They offer better interest rates than banks since the risk profile is higher and also offer periodic interest payments. Tenors can range from 1 year to 5 years with both cumulative and regular interest pay-out options available. Every corporate paper has a rating depending upon the criteria of the rating agency and this broadly defines the interest rate it will be offering on its Deposits. A higher rated (AAA) rated Corporate deposit would offer lesser interest rate than a AA rated CD since the perceived risk is lesser and the investor is better assured of the company not defaulting on its obligations and his funds being more secure. The taxation is similar to that of a bank FD since the payment mode is interest. Post Office Deposits Postal department of India has a wide network of about 1,55,000 offices and are still the most popular method of reaching out to the extreme interiors of this vast country. The Post office savings bank is the most widespread and largest banking system of the country offering providing secure, sovereign guaranteed and attractive investment options for citizens. Post office savings schemes have the savings account for regular cash parking and also recurring and time deposits for longer investments, Monthly Income schemes & Senior citizen savings schemes. Minor and joint accounts can also be opened and accounts can be transferred between post offices. Apart from the above, the post office also offers longer term investment options like Public Provident fund scheme, Sukanya Samriddhi scheme, Kisan Vikas Patra & National Savings Certif Ultra-Short Duration Fund, Low Duration Fund, Liquid Scheme, Money Market Mutual Fund International College of Financial Planning – Challenge Pathway Prep Book Page 31

The mutual fund advertising campaigns in India have introduced the Indian investor to a new method of liquidity management which is seemingly more return and tax efficient. Several categories serving various timelines and purposes are available in the Indian Cash management mutual fund space. Money Market Schemes Mutual funds with underlying papers of extremely short maturities of less than 1 year are called money market funds. They typically maintain average maturities of about 5-6 months yielding about 6.5- 7% p.a. for the investor. These generally do not carry an exit load. The underlying papers are Treasury Bills, Commercial papers, Certificates of Deposit, Repurchase agreements (repo) etc. These are preferred by investors who either are parking monies for the very short term and/or do not appreciate volatility on their short term parking avenues. Liquid Fund Schemes Liquid mutual funds offer pre tax rates of 5.5-6% p.a. while investing in very short tenure paper such as Government securities, call money, treasury bills etc. which have a maximum maturity of 91 days. SEBI has also recently implemented the step down exit load for the liquid funds wherein funds maintained for 1-7 days and redeemed will bear an exit load while funds beyond that will be exit load free. The special feature in liquid funds is the previous day’s NAV if the funds are invested before 1.30 pm. For funds received by the fund house post this cut-off time, the same day’s NAV applies. International College of Financial Planning – Challenge Pathway Prep Book Page 32

Ultra-Short Term Funds Ultra-short term funds are a step higher than pure liquid funds. Offering generally a 0.5-1% higher return and maintaining papers of about 6 months to 1 year maturity, they are also slightly more volatile in their returns than pure liquid funds Low Duration Funds: Low duration funds are a hybrid between ultra-short term funds and short term debt funds. The returns offered by low duration can be higher than ultra-short term funds by about 0.5% p.a. but the volatility of the returns are also higher. Low duration funds can invest in papers of up to 1 year and most maintain an average maturity of about 9-10 months. These also carry a higher expense since it is actively managed and carry an exit load. Sources of Personal Credit/Debt in India Types of Credit One can use various sources to borrow funds from – both organized and regulated as well as un- institutionalized or unregulated. Banks and NBFCs (Non- Banking Financial Companies) are the regulated sources of borrowing funds. Moneylenders, jewellers, chit funds etc. are unregulated sources of credit. Loans and advances from employers are also a form of borrowing which may or may not involve payment of interest. Structured Lending Institutions Of the organised institutions that have a formalized lending structure, banks in India have the most widespread and robust network of branches that cater to the Indian borrower. International College of Financial Planning – Challenge Pathway Prep Book Page 33

The Reserve Bank of India (India’s central bank) issues two types of banking licenses – the Universal Banking License and the Differentiated Banking License. The loan rate is linked to the MCLR (Marginal Cost of funds based Lending Rate) which the banks link to the centralized Repo rate declared by the RBI and the tenors of the loan. Public Sector Banks These are banks that are more than 50% government - owned entities and lend to individuals and corporate borrowers at certain pre-determined rates. There are a total of 12 public sector banks in India. Some examples are State Bank of India, Punjab National Bank, Allahabad Bank, Bank of India etc. A PSB would offer loans such Home loan, home Top-up Loan, Car Loan, Personal Loan, Education Loan, Agriculture Loan, Business and SME loan, Personal Loan, Loan against Gold, Pension Loan etc. Private Sector Banks Banks run by the private sector where majority stake is held by individuals/private shareholders are called private sector banks. HDFC, ICICI, Axis, Yes, Kotak etc. are some of the top Private Banks in India. The threshold for collateral and loan limits are generally higher than those of the public sector banks. A Private Sector Bank would offer loans such Home loan, Car Loan, Commercial Vehicle Loan, Personal Loan Small Banks Small banks are the newest kind that have opened in India as part of an auxiliary banking system. They function under the Differentiated banking license issued by the RBI. Small banks or small finance banks as they are known as are allowed to open savings & current accounts, provide credit to individuals & businesses, provide online banking and payment facilities, International College of Financial Planning – Challenge Pathway Prep Book Page 34

provide forex and carry out all such banking activity for its customers except for issuance of credit cards. They also cannot float subsidiaries and deal in sophisticated financial products. They primarily were created to work on the underserved sections of the society where larger banks have a difficulty reaching. However they do face some restrictions in terms of the loan size and investment exposures they can maintain such as- ● 75% of its credit has to be to the priority sector. ● 25% of branches have to be in unbanked areas ● At least 50 per cent of their loan portfolio has to include loans and advances of up to Rs 25 lakh and so on. Ujjivan, AU small finance, Jana Small Finance are some of the well-known small banks in India. Payment Banks Payment banks also like Small finance banks have the Differentiated bank license. Hence, these function differently from the Universal banks like Public and Private sector banks. The objective of setting up Payment banks just like Small finance banks is to provide small savings accounts facilities and payment/remittance services to low income households, labourers, housewives, small businesses etc. They can carry out most banking activities for their customers except for issuing loans and credit cards, cross border remittances and NRI banking activities. Also, they cannot accept deposits more than Rs. 1 lac per customer. The operations of the payment banks however are fully digitized and technology driven, International College of Financial Planning – Challenge Pathway Prep Book Page 35

Payment banks are generally promoted by Telecom companies, NBFCs, Real estate chains, Supermarket chains etc. that provide micro banking services to their customers as an extended feature. Cooperative Banks Cooperative banks are institutions established on a cooperative basis as part of the Cooperative societies act, 1904 & 1912. They function like normal banks – collecting deposits and issuing loans but primarily concentrate on the rural and agricultural sector more than industry and businesses. Their deposit rates are also generally higher than the normal banks. The structure of cooperative banks is three-tiered – State, Central and Primary cooperative credit societies. Central cooperative Banks – these are generally organized and operated at the district level. State cooperative banks – these are organized and operated at the state level and are direct links to RBI for providing credit to the cooperative sector. Primary Cooperative Bank – these provide credit to businesses and not agricultural usage. Generally these function at the bottom tier in rural areas and villages Citizen Credit cooperative bank, Shamrao Vithal Cooperative bank, Cosmos Cooperative bank are some of the well-known cooperative banks in India. Regional Rural Banks Regional Rural Banks (RRBs) are Scheduled Commercial Banks formed under the RRB Act 1976 which are government owned and function at the rural region levels in various states In India. The stake is generally 50% owned by the central government, 35% by the Sponsor bank and about 15% by the state government. The primary purpose of these banks is to bring rural areas into the banking fold of the country and increase financial inclusion. International College of Financial Planning – Challenge Pathway Prep Book Page 36

There are currently 56 RRBs in India – some examples being Punjab Gramin Bank, Kaveri Grameena Bank, Sutlej Gramin Bank etc. States of Goa and Sikkim and the Union territories of India do not have RRBs. States of UP, Bihar and Madhya Pradesh have the highest number of RRBs In the country Financial Institutions and State Financial Corporations Financial Institutions The term Financial Institutions covers a wide range of organizations from Banks to Insurance companies, brokerages and investment banks. Since lending of funds forms a major part of any FI, these do form a part of organized credit in the country. Their functions can include some or all of the services related to – deposits, loans & credit, insurance, investment services, broking services, forex etc. An FI plays an important role in providing credit to even those companies that are unable to raise credit from the general public. State Financial Corporations State Finance corporations formed under the State Financial Corporations Act 1951 – These are state level financial institutions that play a major role in the development and growth of small and medium enterprises in the State. At present there are about 18 State finance corporations in the country – examples being Andhra Pradesh State Finance Corporation, Himachal Pradesh State Finance Corporation, Rajasthan Finance Corporation etc. The authorized Capital of a State Financial Corporation should be within the minimum and maximum limits of Rs. 50 lakhs and Rs. 5 crores which are fixed by the State government. International College of Financial Planning – Challenge Pathway Prep Book Page 37

The management comprises of a board of ten members - The state is responsible for nominating the Managing director and three other directors. The state government can choose to distribute the shares of an SFC amongst the RBI, scheduled banks, insurance companies, investment trusts, cooperative banks and other financial institutions, provided the number of shares do not exceed 25% of the total shares. The SFCs primarily provide assistance in the form of loans not exceeding 20 years, underwriting of shares & debentures, guarantees, bill discounting to SMEs which could be both private limited companies as well as Partnership firms. Non-banking Financial Companies (NBFC), Housing Finance Companies, Gold Finance Companies, Micro-Finance Institutions Non-Banking Financial companies Non-Banking Financial Companies are quasi banking institutions registered under the Companies Act 1956 that carry out various banking activities but do not have a banking license. A company is generally considered to be an NBFC if the company’s financial assets form more than 50% of its total assets and if 50% or more of its income is coming from financial assets. In spite of not being a bank, Non-Banking Financial companies or NBFCs as they are popularly known as are governed and regulated by the RBI. They offer various banking services such as loans and credits, currency and forex, money management, underwriting, debt syndication, investment banking activities etc. However like a bank, they cannot accept demand deposits and are not a part of the payment and settlement system. The deposit insurance facility available to a banking investor is not available to NBFC depositors. International College of Financial Planning – Challenge Pathway Prep Book Page 38

The broad categories of NBFCs are as follows – - Asset finance companies - Investment company - Loan company - Infrastructure finance company - Systemically important core investment company - Infrastructure debt fund - Micro finance institution – NBFC - Factor – NBFC - Mortgage guarantee companies - NBFC- non operative financial holding company Housing Finance Companies Housing finance companies or HFCs as they are known in India are lending institutions catering primarily to the Housing related loan requirements of their customers. They should have a minimum Net Owned fund of Rs. 10 crore and should obtain a certificate of Registration (COR) from the NHB in order to function as an HFC. Recently RBI has amended regulations to put HFCs on par with other NBFCs. During her 2019 budget, Indian Finance Minister Mrs. Nirmala Sitharaman had moved the regulator of the HFCs from National Housing Board (NHB) to RBI. HFCs particularly finance home purchase, home construction, home extension, home improvement, home renovation which in itself is a big segment in India. However they also provide other loans such as Loan against property, business loans, loans for commercial premises, lease rental discounting on commercial premises etc. International College of Financial Planning – Challenge Pathway Prep Book Page 39

Gold Finance Companies Gold Finance companies capitalise on the love of Indians for their Gold and provide loans to their consumers against their gold ornaments and Bullion. In rural India and even in Tier 2 and 3 towns, Gold continues to remain a major investment and saving vehicle. A gold loan helps the borrower to monetize his asset in times of need. Since gold loan companies are a regulated and institutionalized mode of borrowing instead of going to the local moneylender or jeweller for a loan, they have become immensely popular with the rural consumer. These loans can then be utilised by the borrower for any purpose – personal or business. It is a major help to individuals who have gold but do not have easy access to credit or need a loan within a very short period of time. The primary business of gold loan companies is to keep Gold (bars, bullion, and ornaments) as collateral and provide a loan against the value of this metal at a certain rate of interest and margin to value. They can also diversify into non-core businesses such as home loans, vehicle loans, personal loans, SME finance, Forex services, Micro home finance etc. Muthoot, Mannapuram etc. are some of the well- known Gold Finance companies in India. The interest rate generally lies in the range of 10.5% - 12% p.a. In case of a default, and non-payment of dues after several reminders and notices, the gold finance company can auction the collateral kept with itself and recover the loan amount. Micro Finance Institutions The RBI defines a Micro Finance Institutions as non-deposit taking NBFC with minimum net owned funds of Rs. 5 crores and having not less than 85% of its assets as qualifying assets. The primary target International College of Financial Planning – Challenge Pathway Prep Book Page 40

customer for the MFI is the low income consumer who can borrow money and carry out other such activities such as insurance, remittances etc. for himself via the institution. They also carry out non-financial activities such as training counselling to save, earn, start businesses etc. for the society thus playing a key role in the rural and agrarian sector’s financial inclusion. MFIs in India can exist in the form of NGOs, NBFCs and non-profit companies also known as section 25 companies. The primary features of classification of microfinance are that the borrower is from a low income group, the loan is of a small amount and short duration, no collateral is taken to provide this loan, the repayment period is very short and payments are in high frequency Annapurna Microfinance, Bandhan financial services, Equitas microfinance etc. are some of the well- known MFIs in the country. Unregulated Lending Moneylenders A Moneylender by definition is a person whose business is lending money to others in exchange for interest. Since this is based on individual relationships and the transaction of borrowing and lending is interpersonal, there are no particular laws that exist to regulate these transactions. Chit Funds Chit funds are supposed to be micro lending institutions which may be formal/institutional or casual groups amongst friends and relatives that are called subscribers. In India, the Chit Fund act 1982 regulates these organizations. Some chit funds are formed with a specific purpose of helping a certain group of people with a particular activity. The mode of functioning of a chit fund is typically via lottery or the chit system (this is where it derives its name from). International College of Financial Planning – Challenge Pathway Prep Book Page 41

Cooperative Credit Societies A group of individuals coming together for a common cause, helping each other with financial support and non-monetary services as well such as counselling on business etc. could get a licence as a cooperative credit society, as registered by the Registrar of cooperative Societies. Since the structure is not formalized and regulated, these societies are often run by powerful individuals in the business or region or village- depending upon the nature and purpose of the society. The rates of interest and the collateral requirements are not necessarily high since the lending is being done to members of the society internally. These do not have licenses issued under the Banking Regulations Act, 1949 and hence do not have the approval to accept deposits from non-members. Credit/Debt Management The basic meaning of debt is a sum of money that is owed or due. When a person borrows some money from another with the intent of returning it at a later date with or without any compensation for the interim period of having borrowed these monies, such a borrowed sum is called Debt. Debt can be of various forms: 1) Secured – Any debt or borrowing secured with a collateral or an asset which has been pledged with the lender is called secured debt. The lender may do all sorts of security checks to ensure the borrower’s background however he may still need some security in the form of a hard or financial asset to secure himself in the event of a default. Home loans, car loans, loan against shares or property are called Secured Debt 2) Unsecured – International College of Financial Planning – Challenge Pathway Prep Book Page 42

Debt which is not backed by an asset pledged with the lender is called unsecured debt. Since the only recourse available to the lender here is going to court, this is a highly risky form of lending. Hence, the lender also charges a fairly high percentage of interest to issue such a loan. Personal loans, credit card debt are unsecured debt. 3) Productive – Debt or loan used to purchase an asset which will appreciate in value or provide some kind of income is called Productive debt. Essentially when the borrower has created some value for himself with the amount borrowed, it is productive. A home loan is a productive loan 4) Unproductive- Debt or loan used to consume or spend for momentary requirement, emergency or pleasure is called unproductive debt. Credit card spends are one such example of unproductive debt since it is momentary pleasure of purchasing something without the creation of an asset which will yield something in the future. 5) Revolving – Debt which is not fixed in amount on day 1 of the transaction and can fluctuate over a period of time is called Revolving debt. This essentially implies that the lender has done his checks and opened a line of credit for the borrower. The borrower can now draw as much sum required by him and can also keep repaying as much as he may like during the tenure of the contract. Credit cards, line of credit are some of the well-known revolving credit methods. 6) Mortgage – A type of loan where the asset purchased with the amount lent is completely pledged to the lender is called Mortgage. International College of Financial Planning – Challenge Pathway Prep Book Page 43

The most common type is the home loan wherein the house is pledged to the borrower for the entire lifetime of the loan. CIBIL Score and Purpose Transunion CIBIL was originally established as CIBIL in August 2000 based on the recommendations of an RBI committee. CIBIL stands for Credit Information Bureau India Limited CIBIL collects and maintains credit records of individuals as well as commercial entities This is the first credit information company established in India and has a large number of members in the form of banks, insurance companies, housing finance companies, NBFCs etc. who use its services to gauge the creditworthiness of its borrowers. In the year 2017, Transunion, an American consumer credit information agency, acquired a 92% stake in the company, thus making it Transunion CIBIL. A CIBIL report tracks and monitors the loan repayment history and characteristics of the Indian borrower. A CIBIL score is generally a number between 300 and 900 depicting the credit worthiness and trustworthiness of a borrower of repaying the loan and interest payments in time. Generally a score of above 750 is considered ideal for obtaining a loan. Up to a range of 550 is considered a bad score. One can check one’s CIBIL score either at the time of applying for any loan, or by applying for the score report on their website on paying a small fee. The purpose of a CIBIL score report is to showcase to the querying institution the past track record of payments of the borrower, instances of delayed or missed payments, write-offs, loans taken as a proportion of one’s income, reliance on unsecured loans such as credit card debt/personal loans etc. Types of Loans to Finance Varied Goals There are several types of loans one can borrow for various requirements during one’s life stages. International College of Financial Planning – Challenge Pathway Prep Book Page 44

Every loan has a different purpose, differing tenure, different eligibility (as in who can borrow that type of loan) and repayment methodologies. Consumer Loan, Personal Loan, Credit Card Debt, Vehicle Loan Consumer Loans Loans provided to borrowers for aspirational purchases are typically called Consumer Loans. The intent of the loan is to purchase the asset for consumption while repaying the lender in instalments with interest over the lifetime of the product. Home loans, car loans, appliance purchase loans, gadget purchase loans etc. are generally purchased under this category. The interest is calculated on reducing balance method and the rate is generally around 8.5%-9.5% p.a. the amount is payable in EMI (Equated Monthly Instalments) and the only security is the asset purchased. The loan repayment history and CIBIL score of the borrower becomes critical in granting the loan. The tenure could extend up to 15-20 years depending upon the kind of loan it is. Personal Loans Loans issued to a borrower without any collateral or purpose to fulfil a short term obligation or meet an emergency requirement are called personal loans. There is no guarantee or pledge of any asset nor does the lender know the purpose of taking a loan. It could vary from paying medical bills to meeting expenses at a wedding in the family. The loans are often instantly issued and the rate of interest is fairly high at 13- 14% p.a. The tenure of the loan though is shorter at less than 3 years. This is a high-risk loan for the lending institution and often sees defaults due to the zero-collateral nature. Credit Card Debt Banks or credit card issuing companies such as Visa, MasterCard, American express, Diners etc. issue co-branded credit cards giving their customers a host of benefits such as reward points, lounge access, priority passes, concierge services etc. but these surely do come at a cost. International College of Financial Planning – Challenge Pathway Prep Book Page 45

The user of a credit card is supposed to repay payments due on each of his swipes within 51 days of making the credit card purchase. Beyond this time period, the bank/credit card institution counts this payment as a loan and begins to charge interest on it at a hefty rate of 36% p.a. since this is not a traditional loan and the borrower has not purchased an asset with this credit card, the nature of these transactions could be similar to that of an unsecured personal loan which is of a short tenure. The payment option of Minimum Amount Due to keep the card running merely keeps the card owner’s usage intact. The interest rate continues to be levied and payments continue to accrue despite paying the MAD. A default or late payment on the credit card can destroy one’s CIBIL score the most. Most people in India avoid using this plastic due to the challenge of maintaining the discipline to repay on time. Vehicle Loan A loan taken to purchase a car/bike/commercial vehicle is called a Vehicle loan. These are secured loans since the vehicle is used as the collateral and hypothecated to the lending institution. In the event of a default, the bank can sell the asset and recover their dues. The interest rate is around 8.5%-9% on a vehicle loan and the repayment period is around 4-5 years. The payments are due monthly in the form of EMI (Equated monthly installments) Mortgage, Fixed Rate vs. Variable Rate Mortgage Loan A mortgage loan is one where the borrower pledges his property or any real estate asset with the lender and loans a sum of money against its value. International College of Financial Planning – Challenge Pathway Prep Book Page 46