Quick: what’s the easiest thing to do today (financially speaking)?
If you answered ‘borrowing money’, then go to the front of the class because you are obviously a sharp student and a citizen of the world.
Unlike those days when borrowing money was tough, today, everyone wants to lend you money. Banks, finance companies, credit cards, cooperatives, pawn shops – they all want to lend you money. So they send in pamphlets, flyers, letters, e-mails and even pre-approved loans with attached cheques to you. All you need to do is say ‘yes’, sign the form and the money will be in your bank account in the blink of an eye.
So much so that I think the only qualification that one needs to borrow money today is to have a heart beat! Even people with bad credit report or are in the ‘black-list’ can still borrow money. Just log on to the websites of some cooperatives, and you will see that they proudly display that ‘people in the blacklist can apply.’ In short, if you are alive, then you can borrow!
So again, there are no shortages when it comes to people offering you money.
But should you take up the offer because it’s right in front of you? Should you grab it because it is there? After all, it is fast, easy and convenient. And most of all, it is m-o-n-e-y.
Now while there are a lot of fun things you can do with the money, being someone who wants to create a better financial life (why else would you be reading this magazine?), the answer may be no. Firstly, you are not going to borrow the money just so that you can blow it on some gadgets, trinkets or toys. (Those who plan to do so should be reading Stuff magazine instead!)
You are going to borrow only when you can generate more money with it. In other words, you borrow only when the return from the investment you are going to make is higher than the interest charged for the loan. For example, the return is 10 percent and the interest is 6 percent.
Obviously, you would not do so when the situation is the other way around, i.e. when the return from the investment is lower than the interest charged for the loan. If you say that you cannot find an investment that gives a higher return than the interest charged, then the answer is not to borrow! Wait until you can find one that gives a higher return. I can assure you that there are plenty of good investments if you look hard enough.
But of course, life is not that straight-forward. While the math says that you should borrow when the return on investment is 7.5 percent and the interest is 6.25 percent, what is missing from the equation is the risk involved. Now if both the return and interest are fixed, then it is not an issue, go ahead and borrow. However, often times, both are not fixed, which means they can go up or down. And this being life, it is the return that always drops and the interest that always rises!
This is why you should only borrow when the return exceeds the interest by at least 5 percent. For example, if the interest is 6 percent, the return must be 11 percent or higher. This way, you are building in a safety margin to cater the fluctuations of the rates.
You will no doubt realize that it is not so easy for the above situation to happen. It is rare for the return from an investment to exceed the loan interest by 5 percent. In fact, it is rare for most investments to give a consistent double figure return.
This is why you should borrow money only on two occasions; (1) to buy properties, and (2) to expand your business. Of course, provided that you have done your homework and know what you are doing. Buying the first property you see is a sure recipe for disaster.
This brings us to the most important point of them all; when you borrow money, don’t forget that you have to pay it back, plus interest! And let me further remind you that the people who lent you money do not have a sense of humour – they always want their money back! And some of them will take some extreme steps to get their money back.
So to summarize, do your homework before borrowing money. If you cannot make more money with the borrowed money (while taking a reasonable risk), then do not borrow. Let the people who did not read this article take all the risks instead!