You may think that, because millionaires and billionaires have so much wealth, they would rather pay everything in full and avoid interest rates. But in reality, wealthier people use quite a lot of loans. It’s commonly known, for instance, that billionaires like Mark Zuckerberg still have outstanding mortgages, even though someone like Zuckerberg could certainly pay it off if he wanted. Here’s why even the rich borrow money:
Good debt versus bad debt
Good debt is a form of loan that more than pays for itself. For example, an education loan can result in better job prospects and higher pay; and over the course of one’s career, the higher income will back the loan and interest several times over.
Bad debt, on the other hand, is mainly debt incurred on non-essential consumer goods (e.g., borrowing on a credit card to buy clothes, shoes, tablets). These debts have no positive side, and will only cost you money over the long run.
This has some relation to the concept of leveraging
Leveraging is the use of borrowing to amplify returns. For example:
A person has $1 million in capital, to invest in a portfolio. The portfolio returns around 5% per annum. At the end of the first year, this investor would make $50,000.
Another person, who also has $1 million, borrows an additional $4 million from the bank. This is invested into the same portfolio. $5 million growing at 5% per annum leaves this investor with $250,000, a difference of $200,000 in gains.
Now the borrower does have to pay back the loan at a given interest rate; but if the returns on the portfolio greatly outpace the loan interest, then they can still come out ahead.
The flips side to note, however, is that leveraging also amplifies losses. If the portfolio loses 5%, for example, the unleveraged investor only loses $50,000, while the leveraged investor loses $250,000, plus has an existing loan to pay back.
As such, leveraging needs to be used with care.
Other reasons to use loans and leveraging
Other notable examples include:
- Home loans
- Premium financing for insurance
- Debt consolidation tools
- Collateralisation of illiquid assets
1. Home loans
In Singapore, it’s possible to buy a property with just a quarter of the actual capital needed (assuming you qualify for the maximum loan amount). For example:
When buying a property, the first 5% is paid in cash, while the next 20% can be paid in cash or CPF*. The remaining 75% can be covered by the bank loan.
In this scenario, the loans allows you to purchase a property that costs up to four times the actual amount you’ve paid.
The interest rate on home loans are probably the the lowest you’ll find, compared to any other loan (often around 3.75% at the time of writing). If your property appreciation outpaces the interest rate, it’s almost as if you’re “borrowing for free.”
This is also why some millionaires and billionaires don’t pay the full amount for their property, even though they could.
Rather than lock up their capital in the property, they only pay 25% down, and then invest the 75% in other assets like stocks, bonds, commodities, etc.
This can mean building a portfolio of assets with higher returns than the interest rate, thus optimising their gains.
*Assuming no other outstanding home loans, and a loan tenure of 30 years, which would not extend beyond the borrower’s retirement age at 65.
2. Premium financing for insurance
Premium financing is sometimes used for Universal Life Policies. These life insurance policies are used to cover you for large sums (e.g., $5 million or more), and are typically used by more affluent individuals.
Usually, high coverage like $5 million, or even several million, will cost an impractically large sum. Premiums may, depending on your state of health, cost upward of $1m for a 40 year old male (payable in one lump sum).
As an alternative, some insurers work with banks to apply leverage. The bank will loan you a sum of money to pay your insurance premiums. This will drop your premiums, possibly to as low as 20 to 25 per cent of the usual costs (e.g., $200,000 for $5 million coverage).
You then make monthly repayments to the bank, at a given interest rate.
This allows you to take the capital saved on premiums ($800,000 in the above example), and use it to invest in stocks, bonds, or other such assets. Ideally, the portfolio will match or outperform the interest rate with its returns, thus securing a large amount of coverage at minimal cost.
3. Debt consolidation tools
Some loans can be used as a way to consolidate debt. For example:
Say you owe $40,000 on a car loan at 7% interest, $35,000 on a credit card at 26% interest, and $15,000 in various personal loans at 6 to 9% interest.
It’s quite messy to account for all these loans at varying interest rates.
What you might do is take out a single loan of $90,000, at 7% per annum, to pay off all those debts at once. This leaves you with servicing just a single loan at 7%, which makes financial planning easier.
However, you need to have the discipline not to use more credit, once you’ve consolidated your debts.
It’s important to consult a financial expert before taking this step, as the terms and conditions can be complex. There may be additional transfer fees and loan processing fees involved; and some debt consolidation loans are much cheaper than others.
Beware of balance transfer options on credit cards
This is when one credit card is used to pay off other credit card debts, at a promotional rate such as 0% interest.
Note that these are not actually “free”, as there’s a usually a fee of about 1.5% on the debt being transferred. Also, you only have a time limit of about six months to repay the transferred amount, after which it reverts to the normal interest rate.
4. Collateralisation of illiquid assets
This is when you take out a loan against an illiquid asset, such as precious metals, an art collection, or a property (in which case it’s often referred to as cash-out refinancing).
While there are some variations, the general principle is the same:
Say you have an asset worth $2 million. The lender, often but not always a bank, may loan you $1.5 million at a given interest rate. If you fail to repay the loan with interest, the asset is taken by the lender.
The interest rate is usually lower than an unsecured loan like a credit card, because there’s collateral involved.
The purpose of this is to monetise something without selling it. For example, you may have a $2 million art collection that’s appreciating at 5% per annum. Rather than sell it, you might use the above loan to borrow against it, and then invest the borrowed capital while still retaining your art pieces.
These options are not always available to the general public; but a well-connected wealth manager or other financial professional may be able to find you such deals.
In essence, loans aren’t always a bad thing, provided they’re used intelligently and in a controlled manner. The proverbial devil is in the details however; you need to focus on issues such as whether the interest rate can change, and whether there are hidden penalties (e.g., a fee for trying to repay the loan earlier than expected).
Reach out to us on Single Digit Millionaire for more help on using loans and leverage, and we can put you in touch with the right professionals.
