Mutual Fund Myths

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A few myths about mutual funds.

Myth 1) While choosing between two MFs one should buy one with lower Net Asset Value(NAV).
NAV of a mutual fund depends on the duration for which the fund has been in existence and its performance. Rather than looking at the NAV one should look at the past performance to compare the funds.

Example: Let us assume two funds Fund A and Fund B. Suppost that Fund A is currently priced at Rs. 50 and Fund B is priced as Rs 20. Suppose you invest Rs 5000 in both funds, you get 100 and 250 units respectively. Assuming Fund A gives 20 % return and Fund B gives 10% return. The unit price of the funds becomes Rs 60 and Rs 22. Now your investment of 5000 in Fund A has now become 60 * 100 = 6000, and invesment in Fund B has become 250 * 22 = 5500. Thus we see the fund that looked expensive gives better return.

Myth 2) It is better to invest in NFO (New Fund Offer) than buying a existing fund.
Buying a mutual fund through a NFO only means that you are investing in a fund with no past performance. It is better to invest in a scheme with a known past performance record.

Myth 3) All mutual funds come with tax benefit.
Not all mutual fund come with tax benefit. If you invest in a Equity Linked Saving Scheme (ELSS), your investment can be shown under 80(c). These mutual funds come with a three year lock-in. If your fund invest more than 60% of the corpus into equity and you hold the fund for more than a year, the return made on the investment is tax free. Income from other mutual funds are treated as regular income for the investor.

Myth 4) NAV of a mutual fund always follows the Sensex.
It is possible that the NAV of a mutual fund falls even if Sensex rises and vise versa. Sensex or any other index track only a fraction of companies. The fund you have invested in can invest in these funds and also in other companies that are not part of the index. So it is very much possible that the index and your fund go in opposite direction. But if your fund is a diversified fund it is should follow the index over a long period of time.

Myth 5) It is better to invest in a mutual fund that gives good dividends.
When a fund gives you dividend the NAV of your fund gets adjusted by the amount. Thus the money that you get gets reduced from your investment. This option is mainly useful in ELSS where dividend received is like getting some of your investment back before the lock-in period expires.

Myth 6) You need a demat account to invest in mutual fund.
You need demat account when investing in stocks not for mutual fund. You can just need to fill up a application form, attach the check of the desired amount and submit the form at the mutual fund office or one of the customer service center.

Loan EMIs and Interest Calculations

Some banks are offering loan at 10% some at 11% and some at 12%. Most people think that this is the percentage of interest calculated yearly. After taking loans they get shocked when they see that two borrowers borrowing at same rate of interest of are paying different Equated Monthly Installments (EMIs). Well that is because of one more factor in calculating EMIs that is called reducing frequency. We will talk about reducing frequency in this article and see how they affect the loan EMIs. In general this article will try to explain how EMIs are actually calculated.

When you take loan from a bank they tell you an interest rate which they would be charging on the loaned money. But there are two ways in which they calculate EMIs - one is flat rate system other is reducing balance system. For example you took a loan of 100000 for 20 years and interest rate charged is 10% per annum. Under flat rate system the EMI is calculated as follows:

Interest each year = 10000
total interest = 10000 x 20 = 200000
principle = 100000
total returned money = principle + total interest = 300000
EMI = total returned money / total months = 300000 / (20 x 12) = 1250

Reducing system can be further divided into many systems based on Reducing Frequency. What is this Reducing Frequency? When you repay your loan as EMIs, it has two parts - an interest part and a principle part. How frequently the principle returned, as part of EMI, is subtracted from the remaining balance is called the Reducing Frequency. Suppose the principle returned is subtracted every month from the remaining balance then then balance keeps on reducing each month and interest is calculated on the remaining amount. In this case the reducing frequency is monthly. If the principle returned is subtract once in a year then the reducing frequency is yearly. In that case you end up paying interest on the amount which you had already returned. The more the reducing frequency for a loan the better it is for you (the borrower). How lets see,

The EMI of this loan is calculated using following formula:

EMI = (principal x period interest) ((1 + period interest) ^n) /(m x ((1 + period interest)^n - 1))

where,
period interest = rate in % for the period divided 100
n = number of periods
m = months in a period

Now suppose the reducing frequency is monthly then
period = month
number of periods (n) in 20 years = 240 (i.e. 20x12)
period interest = (10/100)/12 (since 10% is annual interest rate for a month it will be divided by 12)
EMI = (100000 x 10/1200) ((1 + 10/1200)^240)/(1 x ((1 + 10/1200)^240 - 1))
i.e. EMI = 965

If reducing frequency is yearly then
period = a year
number of periods (n) in 20 years = 20
period interest = (10/100)
EMI = (100000 x 10/100) ((1 + 10/100)^20)/(12 x ((1 + 10/100)^20 - 1))
i.e. EMI = 978

These calculations applies to all kinds of loans whether it is House or Home Loan, Personal Loan, Education Loan or any other Loan.