As a FA, people consult me for all sorts of money issues. In the recent weeks, I encountered this question, "should I take a loan to finance my overseas studies or should I try to pay up in full?"
Within the same period, I also met another 2 couples who are contemplating paying up their properties within the next few years.
Debt is a touchy issue. Many people associate the word debt with a bad connotation. As Asians, financial prudence is deeply rooted into our DNA. Many of us are brought up to learn not to borrow money unnecessarily. Hence it is very common for many of us to avoid taking loans unless necessary and sometimes even do our best to pay up our loans as soon as possible.
But, are all debt bad?
Going by the rhetoric of the behaviors surrounding loans, it appears that all loans are no good. Yet, even as a FA, I consciously decided to max out my car loan even though I could comfortably pay up my car in full.
In that case, am I making a booboo financial decision or are all types of loan really bad for us?
In my opinion, there is a differentiation between good debt and bad debt. Knowing how to capitalize on one while avoiding the other can really accelerate the process in making a person wealthier.
This article is written for readers with the ability to pay off their big ticket purchases (other than your own home) in full but are exploring the option on whether taking a loan is viable and sound alternative.
Why is Debt perceived as Bad?
The idea of debt is basically taking a loan. The notion of taking a loan implies you do not have the money available to fund your purchase which is why you need to borrow money from either a person or an entity. Naturally, there's no free lunch. Borrowing money typically comes at a cost. That cost is known as an interest charged to the loan. This additional interest basically makes you pay more for your purchase at the end of the process.
For example, if a car you wish to buy cost $100,000 and you took the maximum loan of 60% at an interest rate of 2% over a 7 year period. Your car will eventually cost $108,400 instead of $100,000.
Above all, if in the event you run into cashflow issues and cannot pay your loan, you run the risk of your asset being repossessed to pay off the loan or heftier repayment penalties.
This is why people perceive a loan as undesirable because it allows people to purchase more expensive items beyond their present affordability with a borrowing cost.
What is a bad loan?
Personally, I define a bad loan as one which is unnecessary. Unnecessary is defined in many ways. Using debt to finance a want that is not a real asset would be unnecessary. For instance, taking a renovation loan so that you have a beautiful house for stay.
Taking a loan to give you peace of mind in cashflow but not utilizing the free cashflow to grow your wealth is unnecessary. You are basically paying the bank for the thrill of seeing more zeroes in your bank balance.
Taking a loan to buy a flashier car simply because you like it is unnecessary. A more affordable car that can bring you from point A to point B with a smaller loan or even paid in full can also serve the same purpose.
You get the idea...
So why did I take a full loan on my continental car when I can actually pay it off in full?
Wouldn't it be deemed unnecessary based on my examples above?
How Good Debt Can Help You
This is where I would like to introduce the concept of Good Debt or Good Loans. The primary premise why the rich get richer is because they know how to exercise financial prudence when utilizing leverage.
Taking a loan to make certain purchases basically enables a person to use other people's money to buy an item. The benefits of this approach included but not limited to:
Improved Cashflow
If we assume a hypothetical example that I paid $150,000 for a car in full, I would have $150,000 less in my bank account. If I needed this money to finance other emergencies or take advantage of new market opportunities, it wouldn't be available.
Financial Opportunity Costs
Also, most car loans interest charged during late 2020 is about 2%. However, my nett investment return for 2020 was about 30%. Assuming a $150,000 car with a 60% loan, that means that $90,000 could be loaned. If I chose to use savings to pay up this $90,000, this means that I would have earned 30% less from this $90,000. On the flip side, if I kept this $90,000 invested and take a loan at 2%, the math would work out like this:
$90,000 * 2% = $1,800 (interest paid per year)
$90,000 * 30% = $27,000 (paper returns gained)
Nett Gain: $27,000 - $1,800 = $25,200 (nett profit if investment was liquidated)
Of course, this assumption only holds true if:
The money is invested and not left idle in the bank
The investment returns are higher than the loan interest
The investment did not lose money
Improved Yield
A car is a depreciating asset so it's probably not a good example for this point. A property though is a potentially appreciating asset. Take for instance if you have $1,000,000 and use it to purchase a house in full... and sell it for $1,200,000 after 5 years. You would have made $200,000 from $1,000,000 which is a 20% return. If we annualized it, it means each year the return is 4%. On the other hand, if you put down a 25% down payment and take a loan at 2%, the overall cash outlay for a 1 million property is $345,967 inclusive of the interest and principal repayment. Now a home sale at the same price of $1,200,000, 5 years later, would yield a gain of $200,000. However, this $200,000 is based on the cash outlay of $345,967 which means that the yield is now 57%. This is an annualized 11.4% gain.
When is it financially viable to consider taking a loan?
So in my case of taking a car loan even though I can pay my car off in full, I'm basically making a conscious decision to retain my cashflow and also make full use of my liquidity to invest at a higher return and offset my low borrowing cost.
Which brings us to the question that motivated this article. Should we take a study loan or should we pay it off in full?
Depends!
Here are the considerations. Firstly, do we need the money if we pay it off in full? For instance, if it eats into your emergency funds and living expenses (if you are studying full-time) then perhaps, the loan is more of a need than a want.
Secondly, are we taking a loan simply because we want to psychologically feel comfortable we have more cashflow? If we do not intend to invest the money for a better return and simply want to slowly pay off the loan in small bites, then maybe it's not a good idea to take a loan. Inflation basically would erode your spending power and on top of which you would incur interest charges.
Thirdly, do you have an instrument that can earn you a better return that fits your risk appetite. If you noticed, I used the money I loaned from my car to invest in equities. Equity investment carries risk and you might incur losses. Hence it is high risk. If you cannot stomach the risk of using loaned funds to invest in instruments that can lose money, are there any other instruments in the market that can give you a better return without so much risk exposure? At the end of the day, you must be comfortable with the known risk of taking a loan and where you deploy your cash on hand.
These 3 key questions will provide greater clarity in terms of whether to take a study loan and even whether to pay-off your home loan.
Summary
Long story short, faster debt repayment or avoiding debt may not necessarily be a good thing. It depends greatly on how you are utilizing the money you have available. Of course, if you aren't putting the money loaned to good use, please DON'T TAKE A LOAN!
Proper use of the liquid cash can provide pretty good leverage for people to benefit from bigger purchases while also ensuring cashflow and profit from it.
Given the present low interest rate environment, there are more options available for consumers to get a better return on their liquid funds. It does not necessarily need to be in instruments that have no downside protection or capped downside risk. Some possible alternatives includes bonds and endowments among others.
Some clients who do not have big purchase needs have also started exploring alternative instruments as a wealth accumulation tool such as leveraged endowments. However, such instruments are not suitable for everyone in the retail space.
Another relevant article: My Outlook For 2020 And New Opportunities Ahead
Ultimately, this article benefits those with the capital to decide if they wish to take a loan or pay-off their purchase in full. I'm personally not a fan of encouraging taking on debt simply to get a higher return when one does not have the cashflow to pay-off the debt in unforeseen circumstances.
After reading this article, you may have some questions or may want to explore some lower risk instruments not discussed in this article. You can reach me by dropping me a message.
Be sure to share the article if you feel this information is helpful. You will enable a lot more people to learn about debt and investments.
About Janice
I specialize in portfolio optimization (ensuring you get maximum value for every dollar you put in) and retirement planning. Clients look for me primarily to outsource their retirement planning needs so that they can focus on other aspects of life that interests them. Many of whom are very good in earning their incomes in their respective professions and wish to ensure their monies continue to work harder while they focus on what they are good at. Refer to client testimonials here.
I've helped many clients who are referred to me reduce the costs they are paying for their insurance or help provide solutions when they deem they are stuck with huge commitments bought when they were younger but unsuitable for their present life stages. You can reach me at 94313076 or my social media accounts on Facebook and Instagram.
Disclaimer: The content created are based on my personal opinions and may not be representative to everyone or any organisation. If you have any doubts or queries pertaining to insurance or investment, please seek professional advice from a trusted adviser in an official setting. You may also reach out to me if you do not have a present adviser using the message box under 'Let's Talk'.
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