Singapore-based financial blog that aims to educate people on personal finance, investments, retirement and their Central Provident Fund (CPF) matters.

Thursday, 17 October 2019

How the Rich Play the Money Game

Interest Arbitrage:
For those of you who have no idea what this phrase means, let me explain it to you.
Interest: interest rates.
Arbitrage: is the practice of taking advantage of a price difference between two or more markets.
Simply put, the rich get richer by taking in a higher interest rate return than the interest they pay on the loan they take.

Simplest Example:
I borrow $1 million from the bank at 2% interest.
I lend it out to someone at 6% interest.
By doing nothing, I earn 4% interest.
Of course, the real-life example is not that simple. But as an illustration to show you the point.

More Common Example:
I buy a house for $1 million.
I put a 10% down-payment ($100,000) and borrow the rest of the $900,000 from the bank.
And yes, the banks are more than willing to lend huge sums of money to rich people than to the average Joe and Jane.
Here's where it gets interesting:
Now, I can negotiate a deal with the bank to not repay them the principal of the loan (the $900,000).
Instead, I will pay only the interest portion of the loan - aka Interest-Only Loans.
The bank, hoping to have my business, will agree to this (competition is tough these days for the banks).
So I now have a property that I can rent out for income, and net me some cash if my rent is greater than my interest payment.
If I want to, I could also lower my rent to equal my interest payment, just to ensure that I got someone paying my interest for me.
Here's why it makes sense to do that - warning: a fair amount of maths below.

Recommended Post: CPF LIFE Payout Sum's Difference

Properties tend to increase in prices in the long-term (agreed?)
Properties probably can average a 6%-8% return per year in the long-term (rent + capital appreciation, agreed?)
Interest rates probably won't go beyond 5% in the next 10 years
So essentially, what I, as the rich have done, is borrowing other people's money (the bank's money) cheaply to invest for returns that exceed the cost of my loan. 
The only thing I have to ensure is that I have money to pay my interest payment and that I can last long enough for my property to appreciate significantly in value so that I can sell it for a profit.
Simplified mathematics: 7% return - 4% cost = 3% net return per year on average over 10 times

Now, the property is not just the only tool used for such action.
Those of you who trade in Forex and commodities will understand that you all leverage to earn extra money.
Stocks have leverage (brokerage firms allow you to borrow up to 2x the capital you put with them).
When you buy your HDB, you are also essentially hoping to sell it in the future to reap a good profit when you are near your retirement, that is also a form of interest arbitrage.

Now, that is not to say that such arbitrage doesn't come without risks.
If you cannot pay your interest-only mortgage, the bank seizes your property (think 2008 Financial Crisis).
If you cannot provide enough funds to support your trading positions, the brokerage firms will sell out your positions in stocks, Forex, commodities, bonds, or other trading assets to recover their money.
You need to have enough planning and financial resources to cover the risks involve (you must have money to pay your loans when you got no tenants paying for you).
It takes a huge understanding of how asset classes (stocks, bonds, properties, etc.) work to be good at this.
For example, the probability of the stock market being positive over any 10-year period is almost 90+%. If you could borrow at 2% interest, invest over the long-term in the stock market that gives you a 7% average return per year, you earn 5% without putting any of your own capital. But the problem arises when the market is down (and the stock market can be down 30% or 50% in less than a month), under such circumstances, do you still have the resources to pay the 2% interest you incur every month?

Recommended Read: Why stocks are better than HDBs

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  1. MAS do not allow interest only loans.PERIOD.

    1. Hi,

      Thanks for clarifying :)
      We actually meant to use that as an example since Singaporeans are more familiar with property than any other asset classes :)

  2. Don't talk nonsense and get people into trouble with all your suggestions.