Let’s say you receive a bonus worth RM 20k. Apart from spending it, there are 2 options as to how you can utilise it: invest or settle debts. Both of these options can contribute to your finances. The question is: “Which of them is better?”. So, in this article, if you happen to be in such a position, I’ll list down 4 main factors that you can consider to make a suitable decision on it.
Factor 1: Liquidity
For example, if you spend RM 10k a month on living expenses, it is ideal to have RM 60k set aside as reserves (6 months). Obviously, if your expenses are higher, you may need more reserves. Hence, if the amount of reserves you now have is under 6 months of your living expenses, it is wise to consider keeping it without either investing or paying off debt. You may stash away the RM 20k in local FDs, money market instruments or digital cash management platforms like KDI Save.
KDI Saveis offering the following effective annual rate:
Tier 1: RM 100-RM 50k = 4.0%
Tier 2: RM 50k-RM 200k = 3.5%
Base Tier: RM 200k and above = 3.0%
But, if you have more than 6 months worth of liquidity, you can move onto:
Factor 2: Debt-Service Ratio (DSR)
Supposedly, you have 2 types of debt:
A mortgage worth RM 1 million.
A car loan worth RM 20k.
If you choose to lower your mortgage to RM 980k, you are required to continue your mortgage instalment payments to your bank in full as usual. Yes, you could save on interest. But, it won’t help you in terms of cash flow and reducing your debt-service ratio (DSR).
But, if you choose to settle off your car loan, you will free up monthly cash flow, lower DSR and enjoy some interest savings. Let’s say your car loan instalment is RM 1k a month. Obviously, you would benefit immediately with RM 1k a month in extra cash flow. The RM 1k a month can be used to add onto investments like EPF, ASB, stocks … etc.
Otherwise, if you are into real estate, the reduction of RM 1k per month in debt instalments might equate to RM 150k-RM 200k in additional mortgage eligibility. This would widen your options as to what property you can invest in next.
Hence, if the debt you intend to settle could lower your DSR, it is more worth it.
Factor 3: Interest Cost
Once again, you have 2 types of debt:
A mortgage costing 4% per annum
Outstanding credit card debt costing 18% per annum
Obviously, it is wiser to repay or lower your credit card debt. It’s a no-brainer as most investments typically do not offer 18% a year in guaranteed returns. If you find any that are offering beyond 18% per annum (guaranteed), please run as in most cases (99.9%), they are scams.
As for the 4% a year in mortgage interest, there is less incentive to repay it for it is quite possible to find investments that yield >4% per annum. Heck, our debts are in MYR which have depreciated against SGD and USD over time. This means our debts would depreciate over time. So, if you convert your RM 20k into SGD, you would be better off as SGD holds its value better than MYR (unless, you are hoping that S$1 = RM 2 someday in the future).
The higher your interest costs, the more worth it for you to pay off your debt.
Factor 4: Investment Options + Experiences
If you pay off debt, you are certain to reduce debt and save on interest costs. In other words, it’s a sure gain.
But, we cannot be certain for most cases if you choose to invest. Yes, you would stand a chance to earn more in returns: cash flow + capital gains. But, this could differ depending on factors such as:
Your investing skills + experiences.
Investment options + opportunities.
So, if you are a skilled investor, who has accumulated >3 years of experiences in investing and building portfolios, the probability of success is higher. However if you are a newbie, then, your reliance on “luck” for success is higher.
Hence, if you are a savvy investor, the RM 20k received will be capital which are investable into income-producing, asset-appreciating investments: stocks & real estate. Otherwise, if you aren’t that savvy, you may consider paying off debts or opt for vehicles that offer capital-guaranteed returns like EPF & ASB.
There is no one-size-fits-all answer to this question. It boils down to suitability.
In short, it would be ideal for you to consider settling debt if:
- It helps to reduce your debt-service ratio (DSR).
- You incur high-interest costs on your debt.
- You are not a savvy investor.
- Investing would be a suitable option if:
- Your DSR is low.
- You incur low-interest costs on your debt.
- You are quite savvy in investing matters.
By Ian Tai, a financial consultant who writes or KL Lau on his financial investment blog udner the same name.