Monday, July 6, 2009

Financial Leverage

Traditionally, normal people will think that debt is a tool for those who cannot afford to buy something, and borrow money from someone else to pay or buy whatever they need or desire. Debt often relate to something which is bad and most people will advice to settle the debt first before doing something else.

But rich people think differently. Some of above statement might be true, but, it might be not. Debt can be classified into 2 catogories :
1. Good debt
2. Bad Debt

Good debt is we borrow the money and put more money into our pocket. While bad debt is simply taking the money out of our pocket.

Most of the E quadrant people will use loan as a bad debt tool - such as buying a big house to live, buying a car that they can't afford to. I'm not saying that buying a house is a bad debt. It depends whether it puts money into your pocket or outside of your pocket.

ASB loan is the easiest example of good debt. Why I said so?
Let say if I loan RM20,000. I need to pay a month about RM110 for 20 years.
meaning, 1 year I need to pay RM1320.
Normally ASB will give out dividend at 8%, which give RM1600 per year.
This give us a solid RM280 per year and after 20 years, I will get back my RM20,000.
Which total I will receive is about RM25,600 per year by using the banks money.
This is true without the compounding interest. If the interest is compounding, you will surprise the amount of money you will receive by using Other People's Money (OPM) which in this case is the bank's money. Imagine you loan out RM200k. Than just simply put another zero at the back of the equation.


This concept is called leverage. If you can earn more money than what you are borrowing, than the debt is consider a good debt. Earning this money can be classified as passive income, since you not need to do anything after approval of your loan and set down a standing instruction.

You can do the same concept in buying property. But make sure, the amount of your repayment is lower than the income you made (from rental).