Many people are advocates of being debt-free.
They opine that being debt-free frees them from paying interest costs.
That opinion is excellent if you wish to remain in a middle-class society.
But, if you have a sincere desire to be well-off, I would like to share a thought with you about debt and its relationship with all of us.
If you are new to finances, let me start with the basics.
There are two parties in a loan agreement: The Lender and The Borrower.
The lender lends money to the borrower and will be compensated with interest income for he had ‘temporarily’ given up his rights to use his own money to the borrower.
The borrower receives money from his lender and has the choice to use it as he deems fit. To have that choice, he has to compensate his lender with interest.
Here are some examples of who lenders and borrowers are:
Which side are you?
Are you a borrower or a lender?
I know you would like to make more money, let your assets work hard for you and generate passive income, non-stop. People with a sound mind would choose to be on the lenders’ side. You want to be the person who has loads of cash, lend it out and make tonnes of money.
The easiest way to be a lender is to deposit your cash in a Fixed Deposit offered by banks. You immediately earn some interests on the very first day. But before we jump into conclusion, please examine the illustration above again. Do you notice any anomaly?
Still can’t find it? Take another minute to look closely on the list of lenders and borrowers. Is there any repeat?
YES! You probably notice that some people are on both sides.
– The most obvious example is the banks. They are the mortgage providers, and they also owe money to depositors.
– Another example is the investors of P2P financing. They are most like credit card users too.
– If you have a mortgage or use a credit card, and you also own an FD, you are on both sides too!
– A landlord is also a borrower if he still serves a housing loan instalment.
So that’s the topic I want to bring to your attention: pay interest to earn interest.
The question is: ‘Are you a lender or a borrower?’
Some of you may wish to be included solely in the ‘lenders’ club. In most cases, you want to be the loaded guy with money to lend for interest income. On the flip side, most of you do not want to be in the ‘borrowers’ club for you find it depressing to keep on paying interest after interest to the lender.
What about myself?
Am I a lender or a borrower?
Personally, I am both a lender and a borrower to somebody.
For instance, I invested in a portfolio of real estate. I am a landlord who collects rental income (interest) from my tenants for their use of my properties. Also, at the same time, I am a borrower as I obtained mortgages to buy my properties. I have to service my mortgages (pay interest costs) to my bankers.
This is the concept of ‘paying interest to earn interest’.
Obviously, we would make the difference or margin between the two.
Guess who is the best in this business of ‘paying interest to earn interest’?
Answer: The Bankers.
You may refer to a bank’s balance sheet as the screenshot below.
It is from the Annual Report 2018 of Public Bank Bhd.
Out of which, I have highlighted two things:
1. Loans, Advances and Financing. It is an asset to the bank for it represents the amount Public Bank Bhd lend to its borrowers (including myself). It would make interest income from its borrowers.
2. Deposits from Customers: It is a liability to the bank for it is money deposited (loaned) by depositors (including myself) and it has to pay interest to me.
Bank’s balance sheet:
Assets = Loans provided to clients
Liability = Deposits from clients
How do banks make money?
First, they collect money from us in the form of savings and current account, fixed deposit, and other types of deposit. It is a debt by the bank to us. As such, they would pay interest (usually at meagre rates) to us.
Second, they are licensed to lend money (most likely, they can create them out of thin air) to borrowers especially to spenders on their properties, cars, goods, merchandise, holidays … etc. and they charge us at a much higher interest rate.
The difference between the two (interest income and interest expense) is huge. Public Bank Bhd reaped RM 7.6 billion in 2018 from the margin between the two, the highest in 50+ years since its founding.
And you know what? This type of business is so lucrative that banks make billions ringgit of profits each year. For example, Public Bank made a net profit of RM4.55 billion in 2018 just from the banking operation.
I want to introduce you to the concept of being the third group of people. They stand on both sides, as borrowers and lenders, just like the bank.
But you got to be a smart money user, and a sophisticated investor to benefit from these relationships.
Therefore, I like to share the following:
- Most of us are both lenders and borrowers.
- The rich have more interest income than interest expenses and thus, receiving net interest income.
- The rest have more interest expenses than interest income and thus, spending net interest expenses.
Question 1: Should I cash out my EPF to pay off my mortgage?
I believe people who are considering the above is looking to be debt-free. That, in a glance, may be a good financial move. But, in my opinion, it is not smart as you are forgoing 6+% in EPF dividends to save 4+% in interest expenses. Hence, this is a classic example of how being debt-free is not wise.
Question 2: Should I cash out my property to pay off my credit card debt?
The answer is yes. This is because, if you have outstanding credit card debt that is a substantial figure, you are paying 18% interest on it. Therefore, it is best for you to get a mortgage (refinance your property) at 4+% per year to pay off your outstanding credit card debt.
Question 3: Should I borrow to invest in the stock market?
For most people, the answer is no. Why? This is because most people are trying to make a quick buck from ‘capital appreciation’, which is not guaranteed. Most people tend to fail as they do not know what they are doing in the market. But, the thing is … your interest payments are guaranteed. If you lose your principal sum of money, how are you going to pay your borrowings back to the lender?
If you are a sophisticated investor like my buddy Peter Lim, that’ll be a different story.
Question 4: Should I obtain a short-term loan to run my business?
That depends on whether it is worthwhile doing so. For instance, if you have secured an order from a client for a product at a fixed price, you may obtain a loan where you can use the money to manufacture and deliver your product to your client. If the profit margin exceeds your interest costs from your loan, I would say … Go for it, Mate!
Question 5: Should I take a mortgage to flip properties?
I recognise property flipping as a method to profit from properties, although it may not be the best of times to do so. But, if you insist, please prepare yourself reserve funds to service your mortgages if you fail to flip your properties. Most don’t and have flopped instead. As you can see, the rich pay interest to earn interest. Most of them do not pay interest to gain capital appreciation.
The rich, like Tan Sri Teh Hong Piow, Founder & former Chairman of Public Bank Bhd is one who knows about debt and has profited billions from this knowledge. The rich, for most, do not have plans to be ‘debt-free’.
Think about it.
Do you think that Tan Sri Teh makes his billions by being debt-free?
Does he have plans to be debt-free?
I bet not. Being debt-free to him is likened to him instructing his staff to pay all of the money back to his depositors to save on interest costs. This is not a smart move for Tan Sri Teh, and I am pretty confident that he will continue to have billions in ‘debt’ for as long as he lives.
I often see people getting advice that if you want to have financial freedom, you have to clear all your debt. If that is true, imagine someone walks up to Tan Sri Teh Hong Piow and said, “Please pay back all the money you owe to the depositors at Public Bank. Those are your liabilities. Pay it off, and only then, you’ll truly enjoy financial independence.”
So, do you still plan to be debt-free?