There are so many investment options and often with very similar returns. How would you choose the best among them? Most of us have a very bad habit of choosing the ones offering the maximum interest rate.
Why is this a bad habit? Because the interest rates can be very misleading. Often these plans come with hidden costs. I will discuss 4 checks you should do to ensure that your selected investment plan is the best.
The Compound Interest Magic (Check 1)
It happens very often that sometimes the companies manipulate the interest rates by changing their compound period.
Not so clear? Let us take an example. Suppose we have 2 investment plans.
Plan 1: Offers 7.9% interest compounded annually.
Plan 2: Offers 7.7% annual interest compounded quarterly.
Which one you think will give more return?
If we go by more interest rule, the Plan 1 should give better returns than Plan 2. However, the opposite happens.But notice the last words (compounded
Notice the last words (compounded annually and quarterly). This is where the Plan 2 made a difference. Even though we have 7.7% annual interest rate, when compounded quarterly, it yields effectively 7.925% interest.
So, if we invest Rs 1,00,000 in both plans. After 5 year, we get Rs 1,46,253 in case 1 while Rs 1,46,580 in case 2.
When you have 2 plans with same interest, the one with smallest compounding period wins over the other. If you are confused, use this calculator to calculate the effective interest
Hidden Costs of an Investment (Check 2)
Often there are costs in an investment which are not visible directly. The only way to know them is to the read the brochure of the investment plan completely. Let me give you an example of one such cost. Suppose you invest in a Fixed Deposit giving 10% interest rate, the interest you receive is liable to TDS deduction(around 15%*). So, effectively you only get 8.5% interest and not 10%. This is just 1 hidden costs.
Sometimes, there can be hidden benefits of some schemes too. For example, if you invest in PPF(Public Provident Fund), you get two benefits. First, the interest is completely tax-free. Plus you can also claim tax waiver on investment up to Rs 1,50,000 under Section 80C of Income Tax.
Not sure what it means?
Suppose, you earn Rs 4,50,000 anually. The income upto Rs 3,00,000 is not taxable but you have to pay tax on additional Rs 1,50,000 around (5% tax). If you invest this Rs 1,50,000 in the PPF, then you don’t have to pay tax on this amount. So, effectively you saved Rs 7500 by investing on PPF.
Variable Interest Rate (Check 3)
Interest Rate changes almost every year(true for most investment schemes). If you choose a longer period investment scheme, they could either offer you fixed interest rate or variable interest rate. The variable interest rate may pose a risk since interest rates can fall down( happens quite often).
However, this may not always be the case. The interest rates may also go up. I personally prefer those with stable returns.
As an example, the interest rates offered in PPF account are variable and change from time to time. While in NSC(National Savings Certificates), you get fixed interest rates.
Hidden Risks of Investments (Check 4)
You should know high returns always come up with high risks. If the investment scheme is giving you high returns, it is a warning signal on the risks it carries. For example, the private company fixed deposits may offer high returns but are riskier than banks.
Another example is mutual funds. The mutual funds are said to give average returns upto 15-20% annually, even more sometimes. However, it may also be the case that you end up loosing money instead of making a fortune.
I offer two solutions for this problem:
- Always prefer public sector companies ( less risky) over the private sector.
- Never invest in the single scheme. Diversify your investment into multiple schemes. It reduces the risks by a greater margin.
Well, I have said all I could. Its your turn to start looking up for the best investment options now. All the best for your future.
Do ask any questions in comments