Recently, there has been a big hike in Islamic banking and Islamic investment instruments and financial products.
Along with US, UK, Middle East and Europe, India too is expected to catch up soon with financial products that comply with Islamic principles of money management and investments.
In this article, I will try to cover the basic principles behind the Islamic financial instruments and their working. A good example of "How Islamic Mortgage Work?" is available here (Opens in a new window)
As per the Islamic laws, charging interest on any transaction is illegal This forms the basis of Islamic investments and mortgages. Hence, it becomes difficult for Muslims to take up loans like home loan, mortgage or any other financial transactions, if they have to strictly comply with their religious faith and Shariyat laws.
Sharia scholars on the council prohibit investments in businesses that charge interest or have a debt ratio greater than a third of their assets. Industrial companies that have financing units, such as Ford Motor Co. and General Electric Co., are among those failing the test. Hence, no investments can be made in these companies. Banking is not the sector for Islamic investments, unless it is an Islamic bank working on Islamic principles.
The Islamic mutual funds also can't invest in companies that generate operating income from un-Islamic activities, including pork processing, tobacco, liquor, pornography and gambling operations. That takes away big companies like Benson and Hedges, Liquor companies, lot of online website companies, etc.
Typically, they end up investing in Energy stocks, like Exxon Mobil and BP, Utilities companies such as FPL Group Inc., textile stocks, etc.
Luckily for moneyed Muslims, there are a number of Islamic Financial Institutions (IFFs) out there catering to the needs of the devout. Over 250 of them to be exact managing funds totalling more than $300 billion (as per data for 2006). And with more and more Muslims interested in pious repositories for their assets, even financial institutions in the West are getting into the act.
According to the Koran, trade is allowed but not interest. Thus Muslims are forbidden from paying or earning interest on their investments and Islamic banks cannot lend their money in the form of credit. Furthermore Muslims cannot invest in companies counter to their religious beliefs, such as those involved in alcohol or gambling, pork products, pornography, or armaments.
The world market is fast growing in for the Islamic Mutual funds and investments. Middle-east has been the front runner in the race to launch the Islamic investment products and funds, but US and Europe did not take much time to identify the opportunity and join the race. The world is already full of financial products and investment instruments that fulfill the Islamic laws of investment.
Not only across the globe, Indian markets are also fast developing such funds. Recent hype in Indian financial industry has led the mutual fund management companies to look into the money management industry complying with Islamic principles, because they know very well that India houses the second largest muslim population in the world (just after Indonesia). Millions of Muslims are still not betting their money in financial instruments just because their working does not comply with their religious faith.
Coming to the returns from such funds, the same concept applies here. Since these kind of funds are restricted to a set of industry sectors, their performance depends upon how the sectors and their stocks have performed. There is no guarantee of anything.
Be prepared to see loads of funds coming in the market very soon.
Thursday, 6 December 2007
Wednesday, 5 December 2007
Arbitrage Trading: Example, Introduction, Overview-1
In this article, I will attempt to introduce the concept of “Arbitrage Trading”
What is Arbitrage Trading? How does arbitrage trading works? How to make profit from Arbitrage Trading? What are the risks with Arbitrage Trading?
Arbitrage trading literally means “Risk Free Profit” . A similar concept can be extended as “Free Lunch” or “Free Money Making Machine”.
Across the globe, traders and market makers attempt to get this risk free profit while attempting to do arbitrage trading.
Let’s take an example:
Let’s say a stock XYZ is listed on 2 stock exchanges: NASDAQ as well as NYSE (Same like Reliance is listed both on NSE and BSE).
So as an arbitrage trader, I attempt to benefit from the stock price difference between the two stock exchanges for the same XYZ stock. Let’s say the XYZ stock is trading at $20 on NASDAQ, and at the same moment, the price at NYSE for XYZ is $20.50. Hence, I spot this price difference, and buy XYZ stock on the exchange where it is available for cheap, and immediately sell it at the exchange where it is costlier.
In the above example, I’ll buy 100 shares of XYZ on NASDAQ with a BUY price of $20 and immediately sell 100 shares at NYSE for $20.5. Hence, in the process (if everything goes well), I make $0.5 per share, or 100 shares * $0.5 = $50 on the trade, within less than a minute.
So, at the end of this exercise, I will have ZERO position in XYZ stocks, i.e. RISK FREE (as I’m not holding anything), and still I make a profit – that’s why RISK FREE PROFIT or ARBITRAGE TRADING.
One of the major reasons for stock prices to move with every single tick of time is because of arbitrage trading. Traders and market makers across the globe keep on continuously buying and selling stocks on one or two exchanges, attempting to get the benefit of price difference. This leads to price change and very high level of volatility in prices of stocks that are traded heavily.
So at the end of the day, if you see a volume of 10 million shares of Reliance stock being traded, then it is possible that a single trader may have bought 1 million shares on NSE and immediately sold them on BSE for a better price – causing a total of 2 million shares to be traded. However, he is having ZERO position at the end.
Interestingly, though traders and market makers across the globe keep on attempting to go for arbitrage trading, they sometimes fail miserably.
The risks involved in Arbitrage trading is no less. One has to simultaneously BUY and SELL.
What if your BUY order gets executed, and your SELL order does not? You end up sitting on a very big number of shares.
Then, what if your SELL order gets executed, but the BUY order does not? At the end of the day, you will be forced to close your position by buying at a higher price – which will result in a big loss.
What if your BUY order for 100 shares was executed, but the SELL order was executed only for 50 shares?
Continue to Part II: How to beat risk in Arbitrage Trading?
What is Arbitrage Trading? How does arbitrage trading works? How to make profit from Arbitrage Trading? What are the risks with Arbitrage Trading?
Arbitrage trading literally means “Risk Free Profit” . A similar concept can be extended as “Free Lunch” or “Free Money Making Machine”.
Across the globe, traders and market makers attempt to get this risk free profit while attempting to do arbitrage trading.
Let’s take an example:
Let’s say a stock XYZ is listed on 2 stock exchanges: NASDAQ as well as NYSE (Same like Reliance is listed both on NSE and BSE).
So as an arbitrage trader, I attempt to benefit from the stock price difference between the two stock exchanges for the same XYZ stock. Let’s say the XYZ stock is trading at $20 on NASDAQ, and at the same moment, the price at NYSE for XYZ is $20.50. Hence, I spot this price difference, and buy XYZ stock on the exchange where it is available for cheap, and immediately sell it at the exchange where it is costlier.
In the above example, I’ll buy 100 shares of XYZ on NASDAQ with a BUY price of $20 and immediately sell 100 shares at NYSE for $20.5. Hence, in the process (if everything goes well), I make $0.5 per share, or 100 shares * $0.5 = $50 on the trade, within less than a minute.
So, at the end of this exercise, I will have ZERO position in XYZ stocks, i.e. RISK FREE (as I’m not holding anything), and still I make a profit – that’s why RISK FREE PROFIT or ARBITRAGE TRADING.
One of the major reasons for stock prices to move with every single tick of time is because of arbitrage trading. Traders and market makers across the globe keep on continuously buying and selling stocks on one or two exchanges, attempting to get the benefit of price difference. This leads to price change and very high level of volatility in prices of stocks that are traded heavily.
So at the end of the day, if you see a volume of 10 million shares of Reliance stock being traded, then it is possible that a single trader may have bought 1 million shares on NSE and immediately sold them on BSE for a better price – causing a total of 2 million shares to be traded. However, he is having ZERO position at the end.
Interestingly, though traders and market makers across the globe keep on attempting to go for arbitrage trading, they sometimes fail miserably.
The risks involved in Arbitrage trading is no less. One has to simultaneously BUY and SELL.
What if your BUY order gets executed, and your SELL order does not? You end up sitting on a very big number of shares.
Then, what if your SELL order gets executed, but the BUY order does not? At the end of the day, you will be forced to close your position by buying at a higher price – which will result in a big loss.
What if your BUY order for 100 shares was executed, but the SELL order was executed only for 50 shares?
Continue to Part II: How to beat risk in Arbitrage Trading?
Arbitrage Trading: Example, Introduction, Overview-2
This is part II of the article: Arbitrage Trading: Example, Introduction, Overview-I. Please start with this first part before continuing with this one.
A simple way to beat the failure in arbitrage trading is to go for effective capital management and keep on doubling your bets if your buy decision goes wrong. However, there has been no sure shot model through which risk-free profit can be made. Ultimately, Arbitrage Trading is nothing but BETTING.
Computers have been used to directly trade using algorithms, using capital management concepts - yet till date - all these algorithms have resulted in big failures.
Take this case; Royal Dutch SHELL (a Holland based Oil company) is listed on both London stock exchange and Amsterdam stock exchange. As a part of my job, I was attempting to test if arbitrage opportunities exist between LSE and AEX.
There were some problems identified firsthand:
• London is one hour behind Amsterdam, so time difference factor had to be considered for pre market, post market and overlapping market timings.
• LSE trades in Pounds, while AEX trades in Euros, hence tick by tick data for forex should also be taken into consideration
Ultimately, after a long running effort, the algorithm was designed, tested and the back-testing showed that it is resulting in very very profitable results.
All set to go, the model was installed with live data feed and we were hoping that the computer will make billions for us, but within 3 hours it wiped off all our capital. Another few weeks we continued modifying the algorithm and testing with live feed from stock markets – it was profitable sometimes; and equally bad, it was in loss same no. of times.
What was hurting the model was the transaction costs. Unfortunately, we could not generate any realizable profitable gains – contrary to the success on historical data, the model was just not able to understand the market scenario. We kept on testing it over a long period of time, ultimately, it was sent to the “Recycle Bin”.
There has been no model in the history of stock markets which has managed to give a consistent and good Risk free return. That was the reason I’d questioned the Quant based “Lotus India Agile Fund” in my review.
The case of ETF is an interesting one. One of the readers had asked “If ETFs are the best bet in the market, why should anyone sell it?”. The reason is “Arbitrage Trading”.
The organizations which issue ETF’s buy the underlying stocks listed in the indices – that too in big number. Hence, they have a net positive position in terms of stocks. To offload that, they issue (or sell) ETF units, at a slightly higher price. Hence, their position is secure, because they do not have any net position, and yet they make decent profits. Ultimately, they have to keep an eye on Index changes, and consolidate their positions accordingly.
Can we individuals benefit from arbitrage trading?
YES – if you take up a fulltime traders job, and keep a constant eye on every single price change in the market hours. At the same time, you should also have big amount of money to play around with and ability to get wiped off completely. And yes, the LUCK factor – because MARKETS ARE EFFICIENT and RANDOMNESS RULES.
One may try his luck if he wishes
A simple way to beat the failure in arbitrage trading is to go for effective capital management and keep on doubling your bets if your buy decision goes wrong. However, there has been no sure shot model through which risk-free profit can be made. Ultimately, Arbitrage Trading is nothing but BETTING.
Computers have been used to directly trade using algorithms, using capital management concepts - yet till date - all these algorithms have resulted in big failures.
Take this case; Royal Dutch SHELL (a Holland based Oil company) is listed on both London stock exchange and Amsterdam stock exchange. As a part of my job, I was attempting to test if arbitrage opportunities exist between LSE and AEX.
There were some problems identified firsthand:
• London is one hour behind Amsterdam, so time difference factor had to be considered for pre market, post market and overlapping market timings.
• LSE trades in Pounds, while AEX trades in Euros, hence tick by tick data for forex should also be taken into consideration
Ultimately, after a long running effort, the algorithm was designed, tested and the back-testing showed that it is resulting in very very profitable results.
All set to go, the model was installed with live data feed and we were hoping that the computer will make billions for us, but within 3 hours it wiped off all our capital. Another few weeks we continued modifying the algorithm and testing with live feed from stock markets – it was profitable sometimes; and equally bad, it was in loss same no. of times.
What was hurting the model was the transaction costs. Unfortunately, we could not generate any realizable profitable gains – contrary to the success on historical data, the model was just not able to understand the market scenario. We kept on testing it over a long period of time, ultimately, it was sent to the “Recycle Bin”.
There has been no model in the history of stock markets which has managed to give a consistent and good Risk free return. That was the reason I’d questioned the Quant based “Lotus India Agile Fund” in my review.
The case of ETF is an interesting one. One of the readers had asked “If ETFs are the best bet in the market, why should anyone sell it?”. The reason is “Arbitrage Trading”.
The organizations which issue ETF’s buy the underlying stocks listed in the indices – that too in big number. Hence, they have a net positive position in terms of stocks. To offload that, they issue (or sell) ETF units, at a slightly higher price. Hence, their position is secure, because they do not have any net position, and yet they make decent profits. Ultimately, they have to keep an eye on Index changes, and consolidate their positions accordingly.
Can we individuals benefit from arbitrage trading?
YES – if you take up a fulltime traders job, and keep a constant eye on every single price change in the market hours. At the same time, you should also have big amount of money to play around with and ability to get wiped off completely. And yes, the LUCK factor – because MARKETS ARE EFFICIENT and RANDOMNESS RULES.
One may try his luck if he wishes
Tuesday, 4 December 2007
Strategies of Financial investment experts
This is an email forward I received. Don’t mean any offence to anyone but I just enjoyed it – Hope you all will do it too :- ))
A young and pretty lady posted this on a online popular forum:
Title: What should I do to marry a rich guy?
I'm going to be honest of what I'm going to say here. I'm 25 this year.
I'm very pretty, have style and good taste. I wish to marry a guy with $500k annual salary or above. You might say that I'm greedy, but an annual salary of $1M is considered only as middle class in New York. My requirement is not high. Is there anyone in this forum who has an income of $500k annual salary? Are you all married? I wanted to ask: what should I do to marry rich persons like you? Among those I've dated, the richest is $250k annual income, and it seems that this is my upper limit. If someone is going to move into high cost residential area on
the west of New York City Garden (?), $250k annual income is not enough.
I'm here humbly to ask a few questions:
1) Where do most rich bachelors hang out? (Please list down the names and addresses of bars, restaurant, gym)
2) Which age group should I target?
3) Why most wives of the riches is only average-looking? I've met a few girls who doesn't have looks and are not interesting, but they are able to marry rich guys
4) How do you decide who can be your wife, and who can only be
your girlfriend? (my target now is to get married)
Ms. Pretty
Here's a reply from a Wall Street Financial trader:
Dear Ms. Pretty,
I have read your post with great interest. Guess there are lots of girls
out there who have similar questions like yours. Please allow me to
analyze your situation as a professional investor.
My annual income is more than $500k, which meets your requirement, so I hope everyone believes that I’m not wasting time here. From the standpoint of a business person, it is a bad decision to marry you. The answer is very
simple, so let me explain. Put the details aside, what you're trying to
do is an exchange of "beauty" and "money": Person A provides beauty, and
Person B pays for it, fair and square. However, there’s a deadly
problem here, your beauty will fade, but my money will not be gone
without any good reason. The fact is, my income might increase from
year to year, but you can't be prettier year after year. Hence from the
viewpoint of financial strategies, I am an appreciation asset, and you are a
depreciation asset. It's not just normal depreciation, but exponential
depreciation. If that is your only asset, your value will be much
worried 10 years later.
By the terms we use in Wall Street, every trading has a position, dating
with you is also a "trading position". If the trade value dropped we
will sell it and it is not a good idea to keep it for long term - same
goes with the marriage that you wanted. It might be cruel to say this,
but in order to make a wiser decision any assets with great depreciation
value will be sold or "leased". Anyone with over $500k annual income
is not a fool; we would only date you, but will not marry you. I would
advice that you forget looking for any clues to marry a rich guy. And by
the way, you could make yourself to become a rich person with $500k
annual income. This has better chance than finding a rich fool.
Hope this reply helps. If you are interested in "leasing" services, do
contact me…
signed,
A Wall Street Big Firm Trader
A young and pretty lady posted this on a online popular forum:
Title: What should I do to marry a rich guy?
I'm going to be honest of what I'm going to say here. I'm 25 this year.
I'm very pretty, have style and good taste. I wish to marry a guy with $500k annual salary or above. You might say that I'm greedy, but an annual salary of $1M is considered only as middle class in New York. My requirement is not high. Is there anyone in this forum who has an income of $500k annual salary? Are you all married? I wanted to ask: what should I do to marry rich persons like you? Among those I've dated, the richest is $250k annual income, and it seems that this is my upper limit. If someone is going to move into high cost residential area on
the west of New York City Garden (?), $250k annual income is not enough.
I'm here humbly to ask a few questions:
1) Where do most rich bachelors hang out? (Please list down the names and addresses of bars, restaurant, gym)
2) Which age group should I target?
3) Why most wives of the riches is only average-looking? I've met a few girls who doesn't have looks and are not interesting, but they are able to marry rich guys
4) How do you decide who can be your wife, and who can only be
your girlfriend? (my target now is to get married)
Ms. Pretty
Here's a reply from a Wall Street Financial trader:
Dear Ms. Pretty,
I have read your post with great interest. Guess there are lots of girls
out there who have similar questions like yours. Please allow me to
analyze your situation as a professional investor.
My annual income is more than $500k, which meets your requirement, so I hope everyone believes that I’m not wasting time here. From the standpoint of a business person, it is a bad decision to marry you. The answer is very
simple, so let me explain. Put the details aside, what you're trying to
do is an exchange of "beauty" and "money": Person A provides beauty, and
Person B pays for it, fair and square. However, there’s a deadly
problem here, your beauty will fade, but my money will not be gone
without any good reason. The fact is, my income might increase from
year to year, but you can't be prettier year after year. Hence from the
viewpoint of financial strategies, I am an appreciation asset, and you are a
depreciation asset. It's not just normal depreciation, but exponential
depreciation. If that is your only asset, your value will be much
worried 10 years later.
By the terms we use in Wall Street, every trading has a position, dating
with you is also a "trading position". If the trade value dropped we
will sell it and it is not a good idea to keep it for long term - same
goes with the marriage that you wanted. It might be cruel to say this,
but in order to make a wiser decision any assets with great depreciation
value will be sold or "leased". Anyone with over $500k annual income
is not a fool; we would only date you, but will not marry you. I would
advice that you forget looking for any clues to marry a rich guy. And by
the way, you could make yourself to become a rich person with $500k
annual income. This has better chance than finding a rich fool.
Hope this reply helps. If you are interested in "leasing" services, do
contact me…
signed,
A Wall Street Big Firm Trader
Monday, 3 December 2007
Trading and Investment for beginners
Recently saw the movie “Om Shanti Om”. Not sure how many of you liked it, but to me it was a clear cut example of “How to make a complete mess of a classic movie called Karz”.
Interestingly, every single item of it was copied ditto from the Rishi Kapoor starrer KARZ. Yet, the producer of Karz, Subhash Ghai, appeared in this copied version. Right from Cricket Matches to TV Reality shows, the actor, actress, producer, director, everyone whole heartedly attempted to promote the movie at every stage.
Despite being a ditto copied version, the movie managed to reap profits. Even people like me who are critics and hate such copied attempts, watched the movies in costly multiplexes, spent a big amount of money on tickets, another big amount on costly pop-corns and parking fee at multiplexes, just to discover that the movie is too hopeless.
Even the ever repeated dialogue was copied from the famous book “The Alchemist” – “If you dream of something, the entire universe conspires to attempt to make it meet with you”
Now the producer, director, actor and all knew that the movie is copied – maybe they had the idea of improving the old classic. But the fact is that it was targeted towards the younger generation of audience, who may have not seen the original. People who have seen the original movie would know that the latest one would no where stand in front of the old classic.
The same thing goes on in the financial world. Every month, a new set of young guns start earning. After some time, when they get sufficient money and savings, they start pondering about what to do with it? Shop, Eat, Celebrate? The question finally leads them to the stock market. Everyone believes that they are there to make money, and it is only the risk taking ability that brave hearts like them need to develop, so that their profits keep on increasing.
The agents, like the film promoters, are there to (mis)guide them. They can open demat accounts for them, assist them with their valuable investment advice and keep collecting their brokerage.
If the person is lucky, he makes profit. It usually takes him a long time to discover what is good and if he is in real profit or not. By the time he discovers it, the broker has collected a big amount of profit from him. It is only then this person realizes that the best ways to invest in into index fund or Exchange Traded funds (ETFs), or an alternative is to be LUCKY with you stock picking skills.
Someone asked me in my previous post that if Index funds are the most efficient alternatives, then why is everyone not investing only in Index funds? To understand this, one should understand how the ETF’s and Index funds are brought into the market. Some details are covered in these articles: ETF and this article
The people who are issuing (selling) ETF shares are the ones who are actually buying the shares of the constituent companies. They do it in large numbers, so they get the shares for cheap. They then create the ETF or Index fund units and sell it in the open market for a bit higher price. Since they trade in huge volumes, they make decent profits.
Unfortunately, as long as the newcomers will keep entering the stock markets with their novice level of knowledge, they will continue to be living under the false impression of stock picking skills and money making strategies. In the long run, one can only be lucky or he will later discover that what he has been doing was not worth as compared to the indices.
Be it a movie, or a cricket match or a casino or even betting on horses and dogs (in western countries), the world is full of examples where newcomers join the stream with a hope to make money – but all meet the same fate in the long run. The sooner we realize our luck and limitations, the better!
Interestingly, every single item of it was copied ditto from the Rishi Kapoor starrer KARZ. Yet, the producer of Karz, Subhash Ghai, appeared in this copied version. Right from Cricket Matches to TV Reality shows, the actor, actress, producer, director, everyone whole heartedly attempted to promote the movie at every stage.
Despite being a ditto copied version, the movie managed to reap profits. Even people like me who are critics and hate such copied attempts, watched the movies in costly multiplexes, spent a big amount of money on tickets, another big amount on costly pop-corns and parking fee at multiplexes, just to discover that the movie is too hopeless.
Even the ever repeated dialogue was copied from the famous book “The Alchemist” – “If you dream of something, the entire universe conspires to attempt to make it meet with you”
Now the producer, director, actor and all knew that the movie is copied – maybe they had the idea of improving the old classic. But the fact is that it was targeted towards the younger generation of audience, who may have not seen the original. People who have seen the original movie would know that the latest one would no where stand in front of the old classic.
The same thing goes on in the financial world. Every month, a new set of young guns start earning. After some time, when they get sufficient money and savings, they start pondering about what to do with it? Shop, Eat, Celebrate? The question finally leads them to the stock market. Everyone believes that they are there to make money, and it is only the risk taking ability that brave hearts like them need to develop, so that their profits keep on increasing.
The agents, like the film promoters, are there to (mis)guide them. They can open demat accounts for them, assist them with their valuable investment advice and keep collecting their brokerage.
If the person is lucky, he makes profit. It usually takes him a long time to discover what is good and if he is in real profit or not. By the time he discovers it, the broker has collected a big amount of profit from him. It is only then this person realizes that the best ways to invest in into index fund or Exchange Traded funds (ETFs), or an alternative is to be LUCKY with you stock picking skills.
Someone asked me in my previous post that if Index funds are the most efficient alternatives, then why is everyone not investing only in Index funds? To understand this, one should understand how the ETF’s and Index funds are brought into the market. Some details are covered in these articles: ETF and this article
The people who are issuing (selling) ETF shares are the ones who are actually buying the shares of the constituent companies. They do it in large numbers, so they get the shares for cheap. They then create the ETF or Index fund units and sell it in the open market for a bit higher price. Since they trade in huge volumes, they make decent profits.
Unfortunately, as long as the newcomers will keep entering the stock markets with their novice level of knowledge, they will continue to be living under the false impression of stock picking skills and money making strategies. In the long run, one can only be lucky or he will later discover that what he has been doing was not worth as compared to the indices.
Be it a movie, or a cricket match or a casino or even betting on horses and dogs (in western countries), the world is full of examples where newcomers join the stream with a hope to make money – but all meet the same fate in the long run. The sooner we realize our luck and limitations, the better!
Thursday, 29 November 2007
What is Home Equity: Introduction, example and overview-1
Home equity is now-a-days becoming quite a common term.
In this article, I’ll attempt to explain it and list the advantages and disadvantages of the home equity.
Home Equity is a concept that originated in the west - for that instance, most of the financial concepts originated in the west. However, home equity has a special significance for the western culture because that fits well into their living and social culture.
What options are available for home buyers?
Imagine yourself as a young salaried individual or a shopkeeper or businessman.
You are working or running your business in a new city, other than your native town, and now you are thinking of buying a house for your own.
One option is to buy the home with your own money – which you may have accumulated from your earnings.
If you don’t have enough money to buy a house on your own, then another option is to take a mortgage or home loan, as most of the individuals do today – committing an EMI repayment for long durations like 115 or 20 or 25 years.
Instead, there can also be a third option, which will also help you in planning your retirement income or pension money – this is the option of home equity.
How does Home Equity Work
You buy a house on loan from a bank, building society or mortgage company. You take this loan while you are working and earning. Say you take a 20 year long home loan when you are 30 years old. Hence, if everything goes well, then at the age of 50, you will finish up repaying all your EMIs and will become the proud owner of your home.
Suppose you have to retire at the age of 58. However, due to your home loan repayment, you were not able to save enough for your retirement. You may have opted for retirement plans like Employee provident fund or private retirement schemes, but at the end you discover that the returns from your retirement schemes are not worth meeting your cost of living after you retire. This may be due to inflation, or bad returns from your retirement scheme or due to dis-savings because of house loan repayments.
So what do you do? You are now the owner of the house. So when you retire, you can use your house to pay for your retirement money.
Continue to Part II of this article
In this article, I’ll attempt to explain it and list the advantages and disadvantages of the home equity.
Home Equity is a concept that originated in the west - for that instance, most of the financial concepts originated in the west. However, home equity has a special significance for the western culture because that fits well into their living and social culture.
What options are available for home buyers?
Imagine yourself as a young salaried individual or a shopkeeper or businessman.
You are working or running your business in a new city, other than your native town, and now you are thinking of buying a house for your own.
One option is to buy the home with your own money – which you may have accumulated from your earnings.
If you don’t have enough money to buy a house on your own, then another option is to take a mortgage or home loan, as most of the individuals do today – committing an EMI repayment for long durations like 115 or 20 or 25 years.
Instead, there can also be a third option, which will also help you in planning your retirement income or pension money – this is the option of home equity.
How does Home Equity Work
You buy a house on loan from a bank, building society or mortgage company. You take this loan while you are working and earning. Say you take a 20 year long home loan when you are 30 years old. Hence, if everything goes well, then at the age of 50, you will finish up repaying all your EMIs and will become the proud owner of your home.
Suppose you have to retire at the age of 58. However, due to your home loan repayment, you were not able to save enough for your retirement. You may have opted for retirement plans like Employee provident fund or private retirement schemes, but at the end you discover that the returns from your retirement schemes are not worth meeting your cost of living after you retire. This may be due to inflation, or bad returns from your retirement scheme or due to dis-savings because of house loan repayments.
So what do you do? You are now the owner of the house. So when you retire, you can use your house to pay for your retirement money.
Continue to Part II of this article
What is Home Equity: Introduction, example and overview-2
This is part II of article What is Home Equity: Introduction, example and overview - 1. Please read this article from part I before continuing with this part
How? That’s where home equity comes into picture.
At 58, when you retire from your job, you approach a home equity finance company like Citibank or Standard Life Property Management. You tell them your situation, your assets (house) and ask them for a home equity plan, which can give you regular monthly income till you die. They visit your house, do an evaluation of the house and then come to a market value of your house. Depending upon this market value, your habits (like smoking), pre-existing diseases, etc., they quote a monthly income to you.
If you accept that offer, then in return you have to sell your house to them, not immediately, but as a “HOUSE EQUITY” – meaning, you sell the house to them as home equity, but retain the possession of your house till you die. Hence, the home equity plan can offer you a very good income at the age when you are no longer able to work. It is called Home Equity,, because like in equity shares, though the shares are sold to the shareholders, the ownership and functioning of the company is retained by the management. Hence, the same concept applies to selling home as equity.
After your death, the home equity company with which you made the contract, will takeover the posession of the house and may rent/sell/lease the house and take monetary advantage.
It all sounds good but the biggest problem with home equity plans is that you cannot leave anything for your family members, once you die. In countries like India, it is quite common to see children becoming rich just by inheriting the parents properties. If the parents decide to go for home equity plans, then the children will not get anything. Even your spouse cannot continue to live in the apartment once you die. He/She too should find something on her own or you must sign the home equity contract jointly, so that even if one of the partners dies, the posession can continue.
The home equity concept is pretty common in western countries, the reason being the social and family life. People like to stay individually, no family commitments, no concept of inheritance of wealth. The concept is “Live today and live for yourself”. It suits well if you believe in that lifestyle.
However, home equity is becoming quite common in India too. The reason is that children now are moving out of their native towns in search of jobs. There has been a major relocation drive. Hence, the parents are now finding it useful to use their property to earn the extra income during the retirement period.
Another issue with home equity plan is that there are not much competition among different firms, as the market is just opening. Hence, people are not getting fair value deals for their house.
The market is still unregulated; hence it’s only between you and the property firm.
Real estate price fluctuation is another major concern.
Another bad news is that people, who are healthy and have maintained a good healthy balanced life throughout their life, will NOT receive good retirement income, because they are expected to live longer. On the other hand, people who smoke, drink and have all kinds of pre-existing diseases will earn more retirement income.
The reason is that the home equity company wants the duration of retirement income payment to be as short as possible. The more diseased a person is, the shorter will be his life span (post retirement) and hence the less no. of monthly payments the property company will have to give him. May be a bit unethical, but that’s how the market works.
Ultimately, by the time you retire, you may see a lot of companies offering this kind of schemes. You never know whether the next generation of kids will be worth inheriting something from their parents, or will our social system (to a certain extent) change such that it may make present day salary earners to go for home equity plans.
Keep watching, markets are developing fast!
How? That’s where home equity comes into picture.
At 58, when you retire from your job, you approach a home equity finance company like Citibank or Standard Life Property Management. You tell them your situation, your assets (house) and ask them for a home equity plan, which can give you regular monthly income till you die. They visit your house, do an evaluation of the house and then come to a market value of your house. Depending upon this market value, your habits (like smoking), pre-existing diseases, etc., they quote a monthly income to you.
If you accept that offer, then in return you have to sell your house to them, not immediately, but as a “HOUSE EQUITY” – meaning, you sell the house to them as home equity, but retain the possession of your house till you die. Hence, the home equity plan can offer you a very good income at the age when you are no longer able to work. It is called Home Equity,, because like in equity shares, though the shares are sold to the shareholders, the ownership and functioning of the company is retained by the management. Hence, the same concept applies to selling home as equity.
After your death, the home equity company with which you made the contract, will takeover the posession of the house and may rent/sell/lease the house and take monetary advantage.
It all sounds good but the biggest problem with home equity plans is that you cannot leave anything for your family members, once you die. In countries like India, it is quite common to see children becoming rich just by inheriting the parents properties. If the parents decide to go for home equity plans, then the children will not get anything. Even your spouse cannot continue to live in the apartment once you die. He/She too should find something on her own or you must sign the home equity contract jointly, so that even if one of the partners dies, the posession can continue.
The home equity concept is pretty common in western countries, the reason being the social and family life. People like to stay individually, no family commitments, no concept of inheritance of wealth. The concept is “Live today and live for yourself”. It suits well if you believe in that lifestyle.
However, home equity is becoming quite common in India too. The reason is that children now are moving out of their native towns in search of jobs. There has been a major relocation drive. Hence, the parents are now finding it useful to use their property to earn the extra income during the retirement period.
Another issue with home equity plan is that there are not much competition among different firms, as the market is just opening. Hence, people are not getting fair value deals for their house.
The market is still unregulated; hence it’s only between you and the property firm.
Real estate price fluctuation is another major concern.
Another bad news is that people, who are healthy and have maintained a good healthy balanced life throughout their life, will NOT receive good retirement income, because they are expected to live longer. On the other hand, people who smoke, drink and have all kinds of pre-existing diseases will earn more retirement income.
The reason is that the home equity company wants the duration of retirement income payment to be as short as possible. The more diseased a person is, the shorter will be his life span (post retirement) and hence the less no. of monthly payments the property company will have to give him. May be a bit unethical, but that’s how the market works.
Ultimately, by the time you retire, you may see a lot of companies offering this kind of schemes. You never know whether the next generation of kids will be worth inheriting something from their parents, or will our social system (to a certain extent) change such that it may make present day salary earners to go for home equity plans.
Keep watching, markets are developing fast!
Subscribe to:
Posts (Atom)