The Power of Leverage (Debt)

Time and time again you see people, especially in the personal finance space, condemn debt/borrowings/loans as something that we should not have to achieve financial freedom.

On the other hand, we have the investing community who loves debt – or in a more sophisticated word “leverage”.

Both are right.. in different contexts.

Hence, there have been a lot of burning questions around about “how much loan should I take?”, “How many years of loan?”, “Should I even take loan for it?”, “Should I pay fully in cash?”

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Understanding debt

Debt is a concept that is frequently associated with banks, whereby money is borrowed from banks to make purchases and will be repaid with interest. In our world, we can borrow for almost everything and anything – house, car, business, personal stuff, etc.

This concept has also extended to other financial institutions and private lenders (e.g. loan sharks), whereby people with less credit score than what a bank is comfortable with can still borrow with much higher stakes (i.e. higher interest, giving a collateral).

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Let’s start with a clean slate

For illustration, let’s talk about BTM, who has not taken any debt before in his life.

He has RM1 million worth of investment that is currently parked in various assets.

On a yearly basis, his investment portfolio could steadily fetch him a modest average return of 5% per year. Any extra is a bonus.

That translates to RM50k per year or RM4k per month.

He does not own a house, a car or anything of that sort. But BTM is now considering to purchase a house, a car and to start a business.

Now that he has reached a certain milestone in life, BTM has set his eyes on:

• A condominium unit with a market price of about RM500k
• BMW X3 priced at about RM300k
• Starting capital of a business about RM100k

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Without Leverage & Debt

If BTM were to be a skeptic to all the debts – “Why should I let bank earn interest on my money?”

Then BTM would pay everything in cash. Total cash required at RM900k.

He has to cash out RM900k, leaving only RM100k in his investment portfolio. The other question would be which investment asset to take out from?

But let’s leave that aside for now and assume that he will be able to maintain his 5% investment returns yearly. So with RM100k left, he will be earning only RM5k per year or RM417 per month!

At least, he will own RM900k worth of asset debt-free.

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With Leverage & Debt

On the flip side, if BTM is all for debt and he will maximise what he can get…

Then BTM will allocate as such:

• House down-payment 10%: RM50k
• House mortgage: RM450k for 35 years @ about 3% interest per annum
• Car down-payment 10%: RM30k
• Car hire purchase loan: RM270k for 7 years @ about 3% interest per annum
• Business capital will be paid in full in cash: RM100k

I’ll get to the rationale of choosing of such in the next section.

In short

Total Cash Required = RM180k
Total Loan Taken = RM720k @ 3% per annum
Investment Portfolio = RM820k @ 5% per annum

Interest vs Investment Earnings:

Interest to be paid for loan taken = RM21k per year or RM 2k per month
Earnings from Investment = RM41k per year or RM3k per month

Are you seeing what I’m seeing?

Granted, the monthly payment of the loan will also include the principal amount so it will definitely be more than RM2k per month. But I also haven’t accounted for BTM’s monthly income from his work / job / business. So let’s just say we net them off for this illustration purposes.

Comparison of the results

The net effect from leverage is that BTM will be able to:
– Maintain a capital of RM820k in the investment portfolio
– Gain an extra RM20k per year or RM1k per month after paying off interests

As compared to without leverage, BTM will only have:
– Investment portfolio only left RM100k
– The returns from the portfolio fetches RM5k per year or RM417 per month

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How does BTM choose for the debt?

For interest, obviously the lower he can get it for, the better.

For the amount of loan to be taken, BTM has to perform his own calculation to ensure that he can stomach the monthly commitment for each of the loan and maximises it.

For the tenure, it differs depending on the loan nature and whether prepayment makes sense or not.
– For mortgage loan, it can be paid down at any time and we will save on all the future interests, so it makes sense to take the longest possible tenure
– For hire purchase, the savings is minimal even if we do settle it earlier, so BTM had to consider how long he will be using the car for as it will not make financial sense to settle the loan early. So, he will only be changing car after paying off the loan. 7 years felt like a good amount of years to be using a car.

I have covered this in detail in another article of mine about whether we should settle our loans early.

For business, he did not want to take loan as the interest rates do not make sense financially (higher than what the investment portfolio can fetch) & there is a risk for the business that he’d rather use cash that is ready to part with.

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Dangers of Leverage

The biggest caveat of all these is that loan are for those who can afford to take them and are disciplined.

As much as there is a lot of benefits for taking up leverage, it is also a dangerous tool as it can cause someone to spiral into bankruptcy if one is not careful.

Debt/loan allows a person to take on more than he/she can chew. BTM doesn’t need to have RM900k to be able to own those things. He just needs RM180k in hand.

Debt service ratio (DSR) is always in the minds of your lenders, but it can only do so much as it doesn’t take into account of what your actual lifestyle needs are.

(FYI: DSR is calculated as total monthly debt payment divided by your monthly net income)

PLEASE REMEMBER: Your lender is not responsible for your financial health. You are!

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Closing Thoughts

These are not purely theory crafting. These are based on my own experiences.

Debt and loans can be a powerful tool in the right hands and a self destructing tool in the wrong ones. It is important to know that it is a double edged sword.

Make sure to cover all angles and grounds before we decide to sign off that loan agreement.