Ever since I was young, I was brought up with the notion that being debt free was the ultimate goal, that your house is the biggest debt and one should strive to pay it off as soon as possible.
Only after working in a bank did I realize this mindset is not 100% correct. Working in a financial institution has opened my eyes to the power of money and wealth management. I realized how people with money invest, use and manipulate money to make even more money.
Firstly, not all debts are bad. There are good debts and bad debts. I didn’t understand this concept for the longest time until I saw a real life case study comparison.
Good debts are debts that appreciate in value. A car loan is considered a bad debt, unless it’s a means for you to earn more money.
Otherwise you’re paying for something that will eventually depreciate into scrap metal.
A housing loan is a good debt, because as housing generally appreciates in value, your home will eventually be worth more than what you paid including interest.
Simple to understand? Now we get to the fun part, loans and compound interest. I realized rich and financially savvy people have several loans. I use to think if they have so many loans, it means they are always in debt, then how did they get so rich?
Then I realized, they were taking loans to pay off other loans to reduce or void interest rates.
In a simple example, let’s say you have a credit card debt of $5,000.
The standard interest rate for credit card debt is 23%. So if you were to pay off this debt over a period of 6 months, you would have paid
$5,340.72 in the end. An additional $340.72 in compounded interest.
BUT, if you were to take up ANOTHER bank loan of $5000 at 0% interest rate with repayment over 6 months, but with a 1 time transaction fee of 2.5% (yes such loans exists) you could pay off the credit card debt immediately, at a total cost of only $5125, saving you a tidy $215.72.
The same logic applies when you take another loan at lower interest rate to pay of a higher interest rate. It’s called refinancing!