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Paying Off Your Mortgage Too Fast Reduces Your ROI


Be Smart with Money!

Using other people's money to acquire assets that generate cash flow is the best form of leverage. Smart investors know how to use debt in their favour to achieve the their financial goals.

rich dad poor dad

For example, the Rich Dad Poor Dad author Robert Kiyosaki owns four Ferraris. But he also has US$600 mil of debt.

Contrary to what some people may think, this is not necessarily a bad thing. To illustrate the point, let's look a hypothetical investment account.

Condition #1

paying off mortgage
paying off mortgage

To invest in Account-H, you must decide how much to put in each month. You can contribute RM500 or even RM10,000 each time. There is no limitation, but it must be consistent.  There is a fixed term. It can be 10 years, 15 years, 25 years, etc. Most people take the 20-years tenure and above. Are you okay with that?

Your thought: “Okay...”

Condition #2

At any time, you can pay more than the amount you had previously determined. For example, if you started with RM500 per month, you can sometimes pay RM750, or RM2,000, or RM5,888. We will accept anything more than RM500. But you cannot pay less than RM500 per month. 

You might ask, “What if I pay less or didn't pay for a few months?” We can forfeit some or all of your previous payments. So essentially your investment in Account-H is not safe from loss of principal.

Your thought: “Eh... That's not nice.”

Condition #3

The more you pay into Account-H, the less return you will get. So as you invest regularly, your return rate goes down gradually.

Your thought: “Ouch... Why would I invest in this account? Doesn't make sense!”

Condition #4

The value you build up in Account-H is not liquid. You can't have it handed it to you and expect to get it within a few weeks. If you want to cash out the money, we need to do a lot of paperwork, and it also involves lawyers. You need to pay for the cost too.

Your thought: “Why would I even consider investing in Account-H?”

Condition #5

The more you invest in Account-H, the higher the taxes you will pay for your income.

You are probably very upset with all these adverse conditions. 

“What are you talking about? Get lost!” you might say.

It is apparent that you don't like Account-H. But here's a revelation: Account-H refers to an amortised housing loan or commonly known as a mortgage. What?!

Let's look at all the conditions and logic. You might want to refer back to the terms above.

A mortgage is a commitment to pay regularly without fail until the loan is fully paid off, usually over a very long time.

When you fail to commit to the installment requirement, the bank can foreclose your property. If they auction off your property at a low price, you can lose everything you paid previously.

For example, a property worth RM1 mil which gets a rental income of RM50,000 a year is fetching a 5% yield. If you buy the property without a loan, your return rate is 5%. When you get 90% financing from banks, your equity is RM100,000. Your return on equity is 50% (RM50,000/RM100,000). 

If your rental yield of 5% plus all future capital appreciation is higher than the mortgage interest, the leverage effect allows you to get a higher return.

As you slowly pay down your outstanding principal, you build up the equity of the property. With a higher stake, your return rate comes down. That's the reason that the more you pay down your mortgage, the return comes down too due to lower leverage.

The equity value of your property is not liquid. You can only cash out by refinancing. That involves a new loan agreement, hence the legal fees. By the time you get the money, it will be a few months later.

When you have rental income on a property with a loan, you can write off the mortgage interest when filing taxes. So the more you pay off the principal, the less interest you can deduct. Therefore, you might end up with more tax liability.

paying off mortgage
paying off mortgage
paying off mortgage

Account-H doesn't look appealing at all. 

But if after reading up till this point, you concluded that you should avoid taking up a mortgage, then you missed the mark. That's not the takeaway advice here.

Look closer. Think hard. Study the details. 

Taking up a mortgage is not a fault. You use other people's money to acquire an asset that churns out income regularly. That's one of the best forms of leverage.

paying off mortgage

But paying down the mortgage fast is the problemWhen you pay extra, when you commit a shorter loan term, and reduce the principal with your 13th-month bonus, what you are doing is:

Turning liquid cash into non-liquid equity, which will cost more to withdraw it out later
Reducing the return on your net worth because you push up the non-liquid equity that does not affect the rental yield you are already getting
Increasing the amount of taxes, you need to pay for your rental income

When in doubt, talk to your financial adviser on how to manage your debts effectively. 

Debt is a double-edged sword that either helps to build or wipes out your wealth. 

With proper financial planning and management, it is possible to use debt to your advantage to become a millionaire. 

When it comes to money: Think smart, act smart.

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