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In this video, we’ll talk about why taking out loans can usually be a GOOD thing for your personal finance.
Before we start, its important to distinguish the 2 types of loans, being a flat rate & a reducing balance loan. Here's an illustration.
Imagine I want to take out a loan of RM100k for 2 years at an interest rate of 10%. A flat rate loan would take 100k multiplied by 10% annually, meaning I’ll pay 10k in interest in my first & second years. In total, I’ll be paying 20k worth of interest.
On the other hand, reducing balance loans work as their namesake. In the first year, you’ll be charged an interest of 10% * 100k, so RM10k. However, since you’ve already paid down some of the principal, which we’ll assume to be RM5k, the balance loan is only RM95k. In the second year, you’ll pay interest of 10% on the balance only, meaning an interest payment of RM9.5k.
This means that reducing balance loans are more favourable to the customers. However, we don’t get to decide this. Personal & vehicle loans are usually flat rates, whereas housing loans & ASB financing is usually a reducing balance method.
Now, let’s go on to why taking loans can be good for your finances. This idea popped up because when Proton recently launched their new X50 model, I’ve been super tempted to get one. And I was considering how much of a down payment I should put.
If i just followed standard personal finance advice off the internet, people would always say put down as much as you can or even more extreme, pay for the whole car in cash. I disagree.
You see, there’s this very important concept that people often overlook and its called opportunity cost. It’s something I learned from Economics class which basically means.. What is the cost of doing something over another?
Let’s say I decide to cut my own grass instead of hiring a gardener, I’d save some money for sure. But I would also be foregoing time I could be spending working on this YouTube channel to generate income. Is it really worth skimping on hiring a gardener then?
If I go to Baskin Robbins and choose chocolate flavored ice cream which btw is the best flavor, the opportunity cost is not getting all the other flavors.
Similar to the 2 examples I just mentioned, the opportunity cost of buying a vehicle in cash or paying a very heavy downpayment is the fact that I am forgoing the opportunity to put this money into an investment.
Now comes the important part. Will putting my money in investments benefit me more than saving on interest by paying for the car in cash? Short answer, yes it will.
“Wait what, how can you pay interest to the bank and be better off? That’s not how it works!”. A lot of people think that. Paying interest is not a bad thing guys. Rich people do it all the time, they utilize credit.
The key here is that the interest I’m paying to the bank is lower than the returns on my investment. Due to the weak economy, Bank Negara has reduced interest rates by so much where I can get 9 year car loans at less than 2.5% interest. This means that I’m paying the bank 2.5% of the amount I’m borrowing every year.
If we take the average 7% annual return on investments, we have a 4.5% spread where we’re making more money by taking the loan. Do note however that the 7% isn’t guaranteed, and it completely depends on how the market performs. However, Malaysians can opt for ASB where you will most definitely get returns beyond the 2.5% mark.
So how can you execute this? Let’s say you have the money to pay for a car outright. Buy it on loan, and put the cash in ASB. Withdraw the money as you need to pay for installments and at the end of the day, I guarantee you you will end up with more money compared to paying full cash.
Even if you don’t have the cash to pay for the car upfront, the concept is still the same. Reduce the monthly payment by as much as you can, meaning stretch out the loan period. Let’s say a 7 year loan has a monthly payment of RM700 and a 9 year loan is RM600.
Take the 9 year loan but commit to “paying” RM700 a month. Rm600 of this goes to your loan and RM100 goes to your investments like ASB. Even though you’re paying more interest with the 9 year loan, you’ll end up paying less for the car after factoring in your investment returns.
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