I believe there is no straightforward answer to this question.
How we approach the subject of debt is often shaped by our own beliefs about it. For instance, if a person views debt as evil, he may choose to be debt-free as soon as possible. He may be looking forward to a day when he has settled all of his liabilities and owns his possessions debt-free.
Is that wrong? Nope.
But, the question is: ‘Is being debt-free financially savvy?’
Here is my take. If you wish to remain in the middle-income group, I believe it is a decent move. But, if you want to be rich and financially free faster, I think, the idea of being totally debt-free is not helpful. In this article, I’ll share my views of what debt is and key considerations for all of us can manage it better:
1. Debt is a Double-Edge Sword.
It makes the rich richer and the rest poorer.
The rich uses debt to get rich for they will borrow at the cheapest interest rates possible to acquire valuable assets which will generate recurring cash flows and grow in value over the long-term. This is often known as good debt.
The rest consumes debt, borrowing at higher interest rates to buy doodads that depreciate in value for their own consumption. This is known as bad debt.
Hence, there are two types of debt. If you read this, I think, it is helpful to begin by preparing a list of your liabilities and identify which group do they belong to. For instance, you may use the list below:
2. If You have Multiple Types of Debt …
You may want to identify which of these liabilities you should be paying off first to strengthen your balance sheet. There are three key factors to be considered.
First, it is interest. I believe it is wise to avoid or to first settle debt with a higher interest rate for it is more costly. Take note: I think it is more practical to make a comparison of your debts based on their effective interest rates per annum. For instance, mortgage rates are based on effective interest rates and thus, needing no adjustments. Car loans are different as they are based on flat rates. It is best to calculate their effective interest rates before comparing it with mortgages.
Second, it is tenure. It is a good idea to have debts with long tenure. I know this is in contrary to some, especially to those who are debt-free advocates. To me, I like longer tenure debts because of inflation. For instance, you have a mortgage of RM 500,000 where the tenure is 35 years and repayment equals to RM 2,500 a month. The RM 2,500 that you pay today is worth more than the RM 2,500 in debt repayments in Year 10, 20, or 35. In other words, you are paying your debt off with ‘cheaper’ money.
Third, it is monthly repayments, which is related to the discussed above. Longer tenure debts tend to have lower monthly repayments. Thus, it is helpful for you in terms of cash flow planning.
Before deciding anything, you may fill in the spreadsheet above with their rates of interests, tenure, and monthly repayments as follows:
3. Debt-Service Ratio (DSR)
From the table above, the monthly debt repayment works out to be RM 6,500.
If a person earns RM 10,000 a month and is accounted for the debts above, his debt-service ratio (DSR) would be 65% (RM 6,500 / RM 10,000 x 100%).
Ideally, it is advisable for a person to maintain a DSR of, at max, 30% in order to be less financially stressful. If a person earns RM 10,000 a month and maintains a DSR of 30%, he may choose to spend 30% of income on living expenses, thus, allowing him to save 40% or RM 4,000 of his income for savings, investments or for financial planning purposes.
But, the above ratio of 30:30:40 is ideal for people who make below RM 10,000 in monthly income. I believe it is okay for you to use debt to invest, thus, raising your DSR at a higher level if you make in excess of RM 10,000 per month.
So, there is no fixed rule on DSR.
If you can manage your DSR with relative comfort, be it 30%, 40%, or 60%, that is okay with me. Once again, DSR formula is as follows:
DSR = (Monthly Debt Repayment / Monthly Income) x 100%
4. Should I Withdraw My EPF to Pay off My Debt?
This is a frequently asked question.
For the past 5-6 years, the EPF has paid out 6+% in dividends (cash returns) per annum to its contributors. Hence, my answer to the question above is: ‘What is the effective interest rate of the debt which you intend to settle?’
If it is for an outstanding credit card debt that charges 18% a year, it is worth it.
If it is for an outstanding personal loan that charges 7+% a year, it is worth it.
If it is for an outstanding car loan that charges 5+% a year, it is not worth it.
If it is for an outstanding mortgage that charges 4+% a year, it is not worth it.
The above is for people who are eligible to withdraw funds from EPF account. It answers by comparing EPF rates with interest cost of one’s debt.
What if you have saved up or receive excess cash in the bank? Should you settle your liabilities with these excess cash? That leads us to:
5. Age, Life Goals, and Purposes
Let’s say, you are below 45 years old and have accumulated RM 100,000 in cash today. Would you choose to:
a. Pay off RM 100,000 worth of mortgage?
On the positive note, you saved on its interest expenses. But, on the down side, it does nothing to reduce your DSR for your monthly repayments would remain the same. Also, you forfeited an opportunity to invest in a new property for RM 100,000 could be used as capital for the property’s down payment, various fees of transaction, and renovation costs.
b. Pay off RM 100,000 worth of car loan?
Congratulations! You might own your car debt-free. If that is the case, your DSR would be further reduced, hence, boosting your loan eligibility. With that being said, it costs you RM 100,000 in investment capital. Is that a good trade-off?
c. Invest RM 100,000 into stocks or real estate.
This is often a popular choice among the rich. But, before you do, I believe, this makes sense only if you do not have high interest debt and are investing mainly for predictable cash flows … not capital gains which are unpredictable. You may use your cash returns to offset recurring interest payments from both mortgage and car loans.
d. Keep RM 100,000 in FD accounts.
But, what if you do not know how to invest or do not have any interest to invest to get rich? You may choose to keep your RM 100,000 in FD accounts.
Today, FD rates are at 3% per year, which is 1-2% different from interest rates of mortgage and car loan respectively. If you keep the money in FDs, you have the flexibility of choosing how you should spend or invest your money in the future at a cost of 1-2% (RM 1,000 – RM 2,000) per annum as compared to using them to pay either your mortgage or car loan.
If you continue to remain clueless on how you should use the money, it is okay. The RM 100,000 can serve as a buffer or reserve to service your debt payments for many months or years to come.
I believe, if you wish to be rich and attain financial freedom faster, one should:
– Use low interest debt to buy assets that pays cash flow and grows in value.
– Avoid and Eliminate high interest debt.
– Stretch debt repayments to longer tenure.
– Keep DSR at manageable levels.
– Boost income to reduce DSR instead of aiming to be ‘debt-free’.