The other day, my friend Elly was telling me that she is considering paying down her property mortgage in full as soon as she has the opportunity. In principle, Elly knows that not all debt is bad, but she still prefers this mode of action.
It seems like she isn’t the only one to think so. A 2015 survey that interviewed 19,000 adults – including 1,000 from Singapore – with primary or shared responsibility for household financial decisions found the following to be the top priorities of our citizens.
The top concern “Owning your own home” reflects Singaporean aspirations and expectations for home ownership. The 4th and 5th top concerns show that Singaporeans know the importance of being prepared for emergencies. The four-letter word underpinning the 2nd and 3rd concerns is the interesting one we will address in this article.
Singaporeans are preoccupied with getting rid of it, just like Elly. If, like her, you too are aware but unwilling to distinguish between good and bad debt, allow us to introduce some thought-provoking concepts.
Have a look at the publicly available financial statements of companies you consider to be successful, and count the number that aren’t under any kind of debt. You might be hard-pressed to find any because nearly all companies operate under some form of debt.
This is because they consider debt in terms of the projected profitability of a venture versus the financing cost. Let’s illustrate with a simple example. Say a particular project is going to cost a company SG$10m upfront and is guaranteed to generate 8% returns annually. The company has access to a special credit line to cover the full upfront cost at 5% per year. This project has an indefinite end-date, and at the end of the project, SG$10m will be returned to the investor. Should the company invest in this project?
The answer should be an emphatic yes. All else being equal, when the rate of return on the money borrowed (8%) is greater than the cost of debt (5%), you are earning “free money” on the difference in interest rates. In real life though, it is likely that the 8% return is not guaranteed, which will complicate the assessment, but the basic concept for the purpose of evaluation remains the same.
Mr Najib Razak, Malaysia’s Prime Minister and Finance Minister, recently pointed out that Malaysia’s debt ratio against its GDP is better than some developed countries. He used Singapore as an example since our debt to GDP ratio in 2016 stood at 112%. So should the Malaysian premier’s statement cause us to panic? The answer is no.
in the case of the Singapore Government, the debt is invested and the investment income is more than enough to pay the debt servicing costs. More importantly, when you consider the assets of the Government, there is no nett debt. That is the other characteristic of good debt – on the nett basis, there is no debt. Money obtained from the debt is not frittered away but works hard in a revenue-generating asset.
Now, having considered the above, let’s come back to my friend Elly and her dilemma. Let’s say Elly rents out an investment property which is fully mortgaged, and she is collecting 5% but paying only 2% on the mortgage amount. In this case, firstly, the monthly inflows are greater than the outflows, which you would instantly recognise as one feature of good debt.
Secondly, it’s almost certain that there is no nett debt. The banks who are lending the money to Elly would have surely performed the due diligence to ensure the value of the property is greater than the amount loaned.
In all the cases above, whether it is a personal, corporate or sovereign debt, it boils down to the same thing – when you borrow to spend and have fun, it’s generally a bad idea. When you borrow to invest, and your investment proceeds can cover the debt servicing costs, that’s considered a good debt. When Elly learns to look at it that way, she can come to a conclusion about whether or not to pay off her mortgage. Sometimes, to understand something, all we need is a paradigm shift.