Leverage – is it really that bad?

We are often told that incurring debt is bad and it is a double-edged sword. Debt can be a scary thing for many people. However, is it really that bad? I will be sharing about good debt vs bad debt in this post and how I personally manage debt to my advantage.

When we talk about leverage, we need to make a distinction between good debt and bad debt. Good debt helps people achieve goals. For example, many people will not be able to own their homes if not for the mortgage loans from banks. Bad debt sets you back with additional burden. For example, incurring excessive credit card balances and unsecured credit which keep rolling at high interest rates.

I tend to think of leverage from the angle of cost of financing compared to the potential yield on my assets (return on investment). If after netting the cost of debt, I can get a decent return on my investment, then I think it is a good debt.

I will share my views on 3 common types of debt.

Home Loan

Most people aspire of home ownership. As property is a big-ticket item, most of us will at some point in life have a bank loan to finance our home. In this aspect, I see home loan as actually a good debt – it allows you to fulfil a dream. This is provided you manage the following aspects:

• Stretch your loan tenor to the maximum so you can manage the monthly loan repayment. You want to have some buffer and set the repayment amount at a manageable amount of your monthly salary. Preferably, the amount can be fully repaid using your CPF (for Singaporeans/PRs).
• Interest rates are low. Pay a bit more and go for fixed interest rates. It gives you a lot more certainty on the repayment amount.
• Pay down the debt as soon as possible when you have excess funds from your employment e.g. bonus, additional funds in your CPF.

Using the above 3 principles, I managed to repay my home loan in 15 years instead of the original 30 years tenor. Being debt free has always been my goal and one needs to stay focused to achieve this as soon as possible!

Credit Cards

I’m sure everyone has at least one credit card in their wallet, if not more. In my opinion, credit cards are great as they give you extended payment terms at zero cost, provided you settle the outstanding balance on time. Personally, I go for credit cards with cash rebates as I don’t fancy getting miles or using points accumulated to exchange for gifts which take up more space in my house.

I do not advocate balance transfers or rolling your credit card debts, as these usually come at very high interest rates.

Investments

There are many leveraged instruments available in the investing world e.g. Futures, Options, CFDs. They all come with varying degree of risks. These are usually used by advanced and professional investors to get higher returns on their investments. Investors should ensure they educate themselves on the risk of the instruments before using them.

We’ve seen a lot of news on how people can get into trouble by borrowing to invest or investing in leveraged products which they do not understand.

“Earlier this year, 31-year-old insurance agent Heng Kai Sheng got advances on three separate credit cards to the tune of $150,000. With the money, he opened a share-financing account at a local bank and pledged the lot as collateral. He was granted leverage of around 3.5 times, a $500,000 kitty Mr Heng’s ploughing into the stock market.

“A price movement of more than 20 per cent within 15 minutes led to one of Societe Generale’s products shorting the stock – DLC SG5xShort SIA – losing all its value after a so-called “airbag” mechanism was triggered, the French bank said in a statement on Friday. Trading of the instrument has since been permanently suspended.

My advice for new investors is to keep it simple and start with buying shares of good companies. Adopt simple dollar cost averaging approach by progressively buying into good companies every month with your excess cash from employment.

Personally, I use a combination of equity and option strategies for my portfolio. If you want to know more about options and other leveraged instruments, pls reach out to me by leaving your contact details.

Conclusion

As you can see, leverage can be good if you use it correctly. It enhances your returns on investment and helps you attain the lifestyle you desire. Use it wisely!