How would you fill in the blank?
Would it be something positive? Or, would it be something negative?
To most of us, we would inevitably be associated with debt in our lifetime. Debt could be the closest to being a certain thing after death and taxes. I believe, it is a fallacy to advocate one to be debt-free or to avoid debt at all cost. As noble as it sounds, I find it to be impractical and, to some extent, not financially savvy.
With that being said, I understand that all of us are different individuals and will be associating the word ‘debt’ differently. I believe our personal views on ‘debt’ are a reflection of our upbringing, life experiences, and our financial knowledge presently.
In this article, I’ll attempt to fill in the blank on what debt is and share my views on how all of us could move one step closer towards financial independence by managing debt wisely.
#1: Debt is …. Money
It has been that way since 1971.
Let me explain:
Prior to 1971, all currencies of the world, including the Ringgit, had their values pegged with the U.S. Dollar. The U.S. Dollar was exchangeable with Gold at US$ 35 an ounce. In other words, before 1971, all currencies had ‘real’ value as they were backed by gold itself. It means, you need gold to issue money.
In 1971, U.S. President Richard Dixon suspended the convertibility of the Dollar into Gold. All currencies have instantly become fiat as they lost their backing of gold. It means, you don’t need gold or ‘anything’ to print money.
Today, the Ringgit, SGD, USD … etc that we hold onto are debt instruments that are issued by governments. It explains why it is important for a country to be of creditworthy. The word ‘credit’ is another word for ‘debt’. A currency is ‘strong’ if its nation is creditworthy. Otherwise, it devalues faster than other currencies.
Since 1971, our government, via Bank Negara Malaysia is licensed to inflate the supply of Ringgit to fuel our economy. You do not need real money such as gold and silver to print money. As a result, we had, and will continue to experience a greater magnitude of economic booms and busts, inflation, and volatility of the exchange rate between Ringgit against other currencies of the world today.
As such, I think hoarding money (Ringgit) is not the smartest method for one to attain financial freedom. This is because, over time, Ringgit would lose its value as Bank Negara Malaysia will continue to increase the supply of Ringgit in order to stabilise our economy … but it will be at the expense of a saver’s wealth.
#2: Debt is … Cheaper if it is backed by Something that Holds Value
Banks are in the business of lending money.
They allow us to buy real estate, cars, furnitures, … etc. In fact, we are the ones who created the economy by inflating the supply of Ringgit through the help of our bankers. Our economy is debt-fueled and hence, needing continuous rise in amount of borrowers to fuel the growth of our economy.
But, banks do not lend money for free. They want to earn interests from us, the borrowers. This is because, as sincere as we are in our promises to pay back our debt, some of us may fail to do so. This is a risk to the banks and it explains why the banks demand interests from their disbursements of debt to us.
In other words, they want to be rewarded for taking risks on us.
If the bank deems us to be of higher risk, they want greater profits (rewards). If the bank views us to be of lower risk, they may ask for lesser profits.
Question: How do they assess risk?
Answer: It depends on what they can do to us if we defaulted our borrowings.
For instance, if you defaulted on your mortgage, the bank would confiscate the pledged real estate from you. Then, the bank would sell off the real estate with the help of an auctioneer to a new buyer. This enables the bank to recover back a significant portion of its original mortgage disbursed to its borrower and thus, making mortgages of less risk.
In Malaysia, the interest rate of a mortgage is about 4% – 5% per year, making it among the cheapest form of debt currently.
However, let us say, you have accumulated credit card debt as a result of paying for a nice vacation in Bali and … defaulted on its debt repayment. There is really nothing of value the bank can confiscate from you to sell it off. Therefore, credit card debt carries higher degree of risk as compared to mortgages.
This explains why the interest rate on outstanding credit card debt is charged at around 15% – 18% per annum, as opposed to 4% – 5% per annum.
Hence, I believe debt is cheaper if it is backed by something that holds value.
#3: Debt is … Bad if it Makes You Poorer.
It stems from one using debt to buy stuff that does not hold value over time.
Mostly, it consists of consumption-based debt. I believe, rather than promoting the idea of being ‘debt-free’, it would be more practical to advocate one to be a person who is free from consumer debt, especially debt incurred for things that do not add financial value in our lives.
It is improbable for one to be financially free if he is paying 18% interest rate on stuff where its value has already been diminished.
With that being said, we may inevitably get ourselves into bad debt for we may, from time to time, demand a higher standard of living.
For instance, we may choose to ‘upgrade’ our car. It looks like we are advancing in our financial lives. But, in fact, it is a regression for you are incurring interests on the new car which loses its value over time. It pays to look good. Here, allow me to state that I am not here to discourage you from ‘upgrading’ to a nicer car.
But, if you intend to move your way into financial freedom, then, it is important for you to identify what a bad debt is – although it is not necessarily bad for one to obtain it for his or her pleasure.
In short, debt is bad if it makes you financially poorer.
#4: Debt is … Good if it Makes You Richer.
You may ask: ‘Is a mortgage to buy a house for my own stay a debt that is good or bad?’
Here is my answer. To me, it is a form of bad debt because it is still classified as a consumption-based debt where the borrower pays its interests from his own pocket. But, it is not the baddest for a mortgage has lower interest rates than a handful of other debt: car loans, personal loans, credit card debts … etc.
Let us say, instead of a personal residence, you invested into a property and let it out for rental income. The amount received is used to pay for its interests on your mortgage and various fees related to owning the property. In this case, as the interest of your borrowings is paid for by another person (your tenant), the mortgage would then be classified as a good debt.
It explains why the richest people on planet earth today owns real estate. They borrow to buy assets that appreciates in value while having their tenants to pay for their interest expenses – which is, by the way, the cheapest form of debt as I write today.
Thus, having good debt makes us rich.
#5: Debt is … to be Managed with Cash Flow.
Today, many have sincere desires to obtain financial freedom through investing in real estate. Most have learnt that debt should be used to acquire real estate.
I am all for it for I am for property ownerships.
But, as much as I am for using leverage or other people’s money (OPM), I don’t advocate one to be highly leveraged, even if it is all intended to be good debt. I find it to be unwise as it is not financially healthy.
Question: ‘How to assess whether or not one is highly or overly leveraged?’
Answer: Debt-Servicing Ratio (DSR). For instance, if you earn RM 5,000 a month and spend RM 2,500 in monthly debt repayments (totalling mortgage, car loan, credit card debt, PTPTN … etc), then, your DSR works out to be 50%.
To be conservative, it is ideal for all to maintain a low DSR, let us say, about 30% at maximum. It offers a buffer for us to withstand against any events which may have a big impact on our finances. Prudence is key.
Question: ‘How can you build wealth sustainably via real estate investment?’
Answer: One of the methods is to invest into income-producing real estate on a gradual basis. Let’s say, you earn RM 5,000 a month and have no debt. You may invest in a property worth RM 300,000 where your mortgage a month is around RM 1,300. Without letting it, your DSR is 26%. But, if you secure a tenant which pays RM 1,100 a month in rent, your DSR would be revised downwards to 21%.
Then, you may invest into another income-producing real estate once you have increased your income in the future.
Question: ‘Should I opt for multiple loan submissions to buy 3 – 4 properties for investment?’
Answer: Personally, I don’t practise it. But, if you are new to real estate, what is your rush? Can your monthly income and savings in hand currently support the level of gearing that you are getting into? Is trying to beat the banking system a smart thing to do in real estate investing? I will leave you to decide what is best for you and your finances.
However, if you wish to be prudent, it is ideal to keep your DSR below 30% or at levels which is manageable. If you find that your DSR is above 30%, then, I think it is helpful for you to focus on boosting your monthly income or cash flows as a means to reduce your DSR levels.
To me, before taking on new debt, it is best for it to be supported by additional income or cash flows.
Now, It’s Your Turn:
Hopefully, you’ve enjoyed the article and learnt a thing or two about debt.
Perhaps, you may want to try to fill in – What Debt Is …
Please feel free to do so … but do it respectfully and constructively as here, we intend to create a community where sound financial ideas are being exchanged and explored conveniently.