I once talked to a business owner who has over ten properties in Penang. 

“Wow, you have so many properties!”

“The banks own it”, he replied, implying that he still owes the bank a lot of money on mortgages. 

Most rich people I know have quite substantial debts, especially long-term loan. To illustrate the point, I will show you a hypothetical investment account.

Watch this video if that helps you learn more effectively:

Condition #1: 

To invest in Account-H, you decide how much to put in each month. You can contribute RM500 or even RM10,000 each time. There is no limitation, but it must be consistent.  There is a fixed term. It can be 10-years, 15-years, 25-years, etc. Most people take 20-years tenure and above. Are you okay with that?

Your thought: “Okay…”

Condition #2:

At any time, you can pay more than the amount you had previously determined. For example, if you started with RM500/month, you can sometimes pay RM750, or RM2000, or RM5888. We will accept anything more than RM500. But you cannot pay less than RM500/month. 

You might ask, “What if I pay less or didn’t pay for a few months?”

We can forfeit some or all of your previous payments. So essentially your investment in Account-H is not safe from loss of principal.

Your thought: “Eh… that’s not nice.”

Condition #3:

The more you pay into Account-H, the less return you will get. So as you invest regularly, your return rate goes down gradually.

Your thought: “Ouch… why would I invest in this account. Doesn’t make sense.”

Condition #4: 

The value you build up in Account-H is not liquid. Don’t ask us to hand it to you and expect to get it within a few weeks. If you want to cash out the money, we need to do a lot of paper works, and it involves lawyers. You need to pay for the cost too. 

Your thought: “Why would I even consider to invest in Account-H?”

Condition #5: 

The more you invest in Account-H, the higher the taxes you will pay for your income. 

You could be very upset with all these adverse conditions. 

“What are you talking? Get lost!”, you might curse. 

It is apparent that you don’t like any bit about Account-H. 

But let me reveal it. Don’t be surprised. Account-H is referring to an amortised housing loan or known as a mortgage. What?!!

What is the logic?

Let me explain all the conditions and logic. You might want to refer back to the terms above. 

#1. A mortgage is a commitment to pay regularly without fail until the loan is fully paid off, usually in a very long time.

#2. When you fail to commit to the instalment requirement, the bank can foreclose your property. If they auction off your property at a low price, you can lose everything you paid previously.

#3. For example, a property worth RM1 million which gets a rental income of RM50,000 a year is fetching a 5% yield. If you buy the property without a loan, your return rate is 5%. When you get 90% financing from banks, your equity is RM100k. Your return on equity is 50% (RM50k/RM100k). If your rental yield of 5% plus all future capital appreciation is higher than the mortgage interest, the leverage effect allows you to get a higher return. As you slowly pay down your outstanding principal, you build up the equity of the property. With a higher stake, your return rate comes down.

That’s the reason that the more you pay down your mortgage, the return comes down too due to lower leverage.

#4. The equity value of your property is not liquid. You can only cash out by refinancing. That involves a new loan agreement, hence the legal fees. By the time you get the money, it will be a few months later.

#5. When you have rental income on a property with a loan,  you can write off the mortgage interest when filing taxes. So the more you pay off the principal, the less interest you can deduct. Therefore, you might end up with more tax liability. 

Account-H doesn’t look appealing at all.

But if after reading up till this point, you concluded that you should avoid taking up a mortgage, then I have failed miserably. That’s not the takeaway advice here. 

Look closer. Think hard. Study the details.

Reread the above conditions and the explanation.

Taking up a mortgage is not a fault. You use other people’s money to acquire an asset that churns out income regularly. That’s one of the best forms of leverage.

But paying down the mortgage fast is the problem. 

When you pay extra, when you commit a shorter loan term, when you reduce the principal with your 13th-month bonus, what you do are: 

– turning liquid cash into non-liquid equity, which will cost more to take it out later

– reducing the return on your net worth because you push up the illiquid equity that does not affect the rental yield you are already getting. 

– increasing the amount of taxes you need to pay for your rental income

Neglecting the equity in your property untouched is a culprit that reduces your investment return. 

KCLau

Superinvestors don’t pay down their debt. For instance, the Rich Dad Poor Dad author Robert Kiyosaki owns four Ferraris. But he also has US$600 million of debt.

Be smarter with money. 


KCLau
KCLau

Personal finance author and trainer

    8 replies to "Why Money-Savvy People Don’t Pay Down Their Debts"

    • Faiz

      Hi KC,

      What if our monthly installment is more than our rental income? Is it more worse?

      • KCLau

        That will require more cash going out.

    • Tey Wei Hsiung

      Thanks sharing

    • Fan Jet

      Hi KC,

      Good articles anyway, but I am not quite understand on the 5th point here.

      “#5. When you have rental income on a property with a loan, you can write off the mortgage interest when filing taxes. So the more you pay off the principal, the less interest you can deduct. Therefore, you might end up with more tax liability. ”

      Can you elaborate more with a detailed calculation example here? How do we write off the mortgage interest?

      • KCLau

        For example, in 2019 you have a property:
        rental income RM20,000
        mortgage interest RM18,000
        other related expense RM5,000
        net loss = RM3000

        Since there is a net loss, you don’t pay income tax for your gross rental.

        If you pay down 50% of the outstanding, your mortgage interest expense is reduced to RM9,000. Then it becomes:
        rental income RM20,000
        mortgage interest RM9,000
        other related expense RM5,000
        net income = RM6000

        You will need to pay income tax for the additional rental income RM6000.

    • Winnie

      Hi KC LAU,
      Thank you for your sharing, I am in this loan refinancing industry. I also doing Insurance.
      I been to Adrian Wee class last year. I do learn many from the 3 days class.
      And understand , there are many more new and make good use of our house to creat and save our money.
      Die with massive Debt

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