Clearing debts early for a "Peace of Mind" is Overrated - Here's why

Updated: Oct 7

A huge range of opportunities open up once you're willing to step out of your comfort zone.


There's this line that's been bothering me a lot for the last two years.


When I first joined Seedly, one of the questions that came up was from someone who was paying off a low-interest loan. I think it was under 2%.


The majority of answers gave this line 'Pay off the debt first, for peace of mind.'

I would nod my head upon seeing this answer. Yes, this seems like good, logical advice.


The average Reward-Risk Ratio


My mindset towards that has changed a bit in the last two years. Let's say I offered you two choices on any given month as an employee:

a) A guaranteed payment of $3000

b) A payment that could range between 0 and $6000.


Most people would choose option (a), because the chance of getting less than $3000 would be exactly the same as the chance of getting more than $3000. With this kind of probability, most people would narrow in on the fact that they might get $0 for their hard work, even though that probability is extremely miniscule.


Psychological studies have shown that for reward-risk thresholds, the average person works on a 2-1 scale. In other words, if I changed option b to something like


b) A payment that could range between 0 and $12,000


It would exponentially increase the probability that the average person would choose option B instead of (a), since the probability of getting a pay higher than $3000 basically doubled, and more average people would be willing to risk getting less than $3000 for the possibility of far more money.


I've stated the word 'average' three times now.


Call it greed, but I'm a Financial Consultant with some pride. I don't want anyone using my services only to end up being just another average person. Otherwise, why bother paying me anything?


If I wanted complete peace of mind - and dear reader, if I wanted you to have complete peace of mind, I wouldn't be talking about this.


If Time is Money, Comfort = Money as well.


Too much time in your comfort zone is incredibly financially inefficient. If there's free advice that I can offer freely, it would be to give up some of that peace for higher financial power. Here's how.


1) Enables higher risk taking (investments)


After working out that his child would likely need at least $80,000 for university fees (location, education inflation, etc) in 15 years, the client is adamant about not contributing more than $3000 a year.


Compounded at a conservative 4%, the projected yield is approximately $62,500.


Offhandedly, he can only:


a) Work harder to provide the rest of the money on his own accord when the time comes


b) Utilise a higher-interest instrument. At 7%, he would be able to completely addressed the need stated.


With good planning, stepping out of his comfort zone would enable him to achieve his goals without having to utilise more capital.

2) Increase efficiency, unlock assets


One of most common debts we will ever incur is a housing loan.


A) A $600,000 loan will incur an annual payment of $65,440. [10 years]

B) A $600,000 loan will incur an annual payment of $32,660 [25 years].


Numbers obtained from CPF Board Monthly Instalment calculator.


It is much easier to use BTIR for such a low interest debt versus a whole life plan, especially when riders are involved. The results are very clear:


A) The total amount at the end of 25 years at a 8% interest rate will yield about $1.92 million. This is assuming that $65,440 continues to be invested for 15 years.


B) The total amount investing the difference for 25 years at an 8% interest rate will be $3.1 million.


C) Adjusted for the fact that the total amount paid in B is higher than A (hence having a higher capital, the total amount adjusted for scenario A will yield about 2.43 million instead.


Even after adjusting in (C), you can see that investing the difference will make far more money. This is a strategy that rich people often engage in order to generate wealth and expand their net worth.

There is a 'flaw' in (2) that I'm going to leave unsaid, a pretty big consideration that I intentionally left out from my calculations.


I hope that someone who reads this and understands it will point it out in a comment or private message, as I have spent the last few months trying to figure it out for two clients.


3) Creates options


Looking back at the options above where you could have

a) $3000 or

b) the range from $0 - $6000,


it is still too little information for someone to base their financial decision on.


While the numbers look great, there are still many other factors to consider.

What factors would shift you towards getting $6000 every month? Which gender are you? What do you need the money for?

Why are you investing and for whom?

The existence of these factors means that despite the 'equal' probability of getting either a) or b) , you would probably earn more than $3000 more often (option b).


It's my job to compartmentalise, explain and add information that will assist you in getting the best out of your financial situation, despite the risks that are on paper.


Takeaways


1) Stepping out of your comfort zone will help you unlock assets you never knew you had.


Consider the example above for your mortgage. As I mentioned - the average person will be unlikely to benefit on a 2 to 1 risk ratio. The benefits in the example alone are less than 25%. But with a calculated plan, the risk is much lower as well.


Similarly, a secondary strategy for the risk-conscious would be taking out a second mortgage for passive income. If done correctly, you create a system of arbitrage that inevitably raises your net worth, but only if you can deal with having debt on paper.


Efficiency and the unlocking of assets usually comes at the expense of some peace of mind.


It simply follows the basic truth of risk and reward.


2) Options. the job of a financial advisor is to create options for you.


If you're lacking the money for your children's education, I can offer you options. If you need protection, I can offer you options.


If you're reading this because you want to incrementally increase your wealth, you should be prepared that more options are going to be available to you - and you may want to consider taking them.


Think back before you started applying financial knowledge to your life. Having the knowledge to invest in yourself should have created a significant income disparity between you (now) and you (past). This knowledge also enlightens you to several things that you can do differently in order to improve your financial status.


As you move forward and inevitably become richer than your past self, you're going to face more and more options that will create an even bigger disparity.


3) Compound interest is truly terrifying.


People should rightfully prioritise insurance over investments when allocating their money. However, it is unwise to leave an investment decision hanging for so long. Every month that you do not begin is another month that compound interest is wasted.


The typical expected return for an equity fund (excluding inflation) is 7%.

This means that in 3 days, you would achieve the same interest return a bank savings account will give you in a year.

Investing; Just do it

It is inadvisable to have a more lacklustre attitude towards investing than insurance. As often said, spending time actually investing in the market is better than trying to time the market.



Money Maverick

As one of the Top Financial Bloggers in Singapore (Feedspot, Withcontent.co), I would be happy to answer any emails and questions you may have, as I have been doing for my readers over the past few years - especially about Insurance and Investing, as it is my forte of personal and professional knowledge.


If you have any such questions about the articles and how it may apply to your finances, you can feel free to leave a comment, or drop a message through any preferred medium (if you prefer privacy).


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Money Maverick is a Licensed Financial Consultant with MAS, who specializes in Investments and Critical Illness Insurance.


The views on his blog are strictly of his own opinion and have no affiliation to any of the companies he works with.


Here are some of my resources on:


1) Investing: Why you should invest aggressively NOW (and how you still can have peace of mind)


2) Insurance: The Newest, Rising Critical Illnesses in Singapore (2019)


3) Retirement and Leverage: Leveraging a Private Annuity, Pros and Cons (ft. Jamus Lim)


4) Spending and Saving: The Biggest Spending Mistakes You DIDNT Even Know you were Making (and how to avoid them)


5) Job Assessment: A Case Study on How a $6k/mth GIrl makes MUCH more money than a $10k/mth Guy


6) Financial Optimisation: How I Avoid the Largest 'Fees' of All


#nowyouknow #honestopinion #insuranceagent #btir #buyterminvesttherest #financialplannersingapore #financialplanning #whereshouldIstart #moneytips #tipsandtricks #moneymaverick

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Money Maverick © 2019 | All Rights Reserved | Disclaimer

The views, opinion and information in all articles are those of the author. These materials do not represent or reflect the views of Manulife Financial Advisors nor is endorsed by them. Manulife Financial Advisors shall not be liable or responsible for the materials of the author. 

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