Personal Finance and Be Money smart! – Part IV: Manage your debts well

Key takeaways:

rich people borrow money to make more money;
poor people borrow money and spend it;
always pay off your debts early and don’t over borrow.

If you borrow $100,000 with an annual interest of 3%, then by the end of the year, you will need to pay $3,000 interest. This makes your total debt to $103,000, if you don’t pay off your principle. If you borrow the same amount of money with the same interest rate, but you could make $20,000 income from that borrowed capital. Then, you have a return of 20% and the cost of that return is 3%, the interest you need to pay the bank. Your net return is 17%.

Doesn’t it sound good? Would you like to do the same? I believe you do!

Borrowing money is good if you can make more money from it. (Photo by Shane Avery on Unsplash)

This is a common situation for different types of people. Most people (like me) will borrow that $100,000 to buy a house and pay the principle and interest over, say 20 yrs with an interest rate of 3%. By the time I pay off my loan some 20 yrs later, I’ve paid the bank $133,000 including the principle ($100,000) and the total interest for that 20-yr period. Unless your house’s value increases over the 20 years and higher than $133,000, you are not gonna make any return out of it, because you still need to live in it and not gonna sell it for cash. For that reason, that debt is deemed as a good debt.

A good debt serves a purpose and the borrower gains from that debt. Examples of good debts include home mortgage (so you are forced to save and own your home), tuition fee loans (so you can gain a degree and earn more afterwards), and equipment loans (so you can buy equipment to earn money). Rich people borrow money in order to make more money. After making more money, then rich people borrow more, reinvest and make more money; creating a flow of ‘liquidity’. That’s how the rich makes money.

Your house is often the biggest investment you’ve made in your life. (Photo by Tierra Mallorca on Unsplash)

Talking about good debts, then we also have bad debts. Examples include buying a $1,500 iPhone by those so-called ‘no-interest’ payment options, or buying a nice $60,000 BMW by a car loan, using a personal loan to buy or payoff other loans, and the worst is actually spend the money out of your credit card! These debts are bad because although they do have a purpose, these debts don’t help you gain much. Can you live without the new iPhone? Can you keep driving your old Ford without buying (and borrowing for) a new BMW? Can you choose not to use your credit card to buy something that you can’t afford right now because you don’t have that cash? The answer is often, yes.

The rich don’t accumulate ‘bad’ debts because they know these debts don’t serve a purpose but costing them money. Many people get into personal financial problems simply because they over-spend and accumulate too many bad debts. The most common channel to over-spend is through credit cards. Literally, one is using ‘future money’ for the moment! The reality is that one still needs to pay off the debt and credit cards are well-known for their high interest rates; typically over 10% and some are like 15% plus.

Most people borrow money and there is nothing wrong with this, but be aware of your debts. The golden rule of personal finance and wealth management is to pay off your debts as soon as possible and limit your borrowing, even for good debts.

(By the way, your brand new BMW will lose 20% after the first year, no matter what. That’s losing about $12,000 after investing $60,000 in the first year… In terms of investment, it’s a guaranteed investment loss every year of the car’s life. That’s why the rich never use own pocket money to buy a nice Porsche. They either have the car paid for by their company or keep driving their own car, because they still need a car! ^_<)

Dr. C. Richard Wu@REEAConsulting.com