IT is important to identify as to which category you belong to.
Are you earning interest on the money you invested or you are servicing a loan and thus paying interest. In the first case you have an asset [i.e. interest earning] while in the second case you have a liability to meet [i.e. interest payment].
Although there is a popular belief that lending is the exclusive right of rich people, whereas borrowing is mostly practiced by poor people, however, I don’t agree to this statement. This is entirely a misconception as both these monetary transactions i.e. borrowing as well as lending forms an integral part of our day-to-day life.
The so called status tag of ‘rich’ or ‘poor’ is a relative term and by application of different parameters, one person on certain occasions may be grouped as poor, while on some other parameters the same person may fall in a group representing the rich in a society.
So whatever be the case, each one of us plays different role sometime as a ‘borrower’ and at some other time as a ‘lender’. On this we must take note of an important principal stating - ‘borrow short while lend long’. In simple terms we know that a borrowing transaction usually invites the payment of interest on the part of the borrower and conversely a lending activity involves the accrual of interest to the lender.
In other words, with every passing day, borrowing increases one’s liability while lending enhances one’s assets. Now the mute question remains, as to how one can use both these monetary transactions such that they lead towards an overall enhancement of assets and not the liabilities per say?
The principle is simple, and of two fold. Let us assume Mr X has accumulated a saving of 1m/-, which in turn has been placed by him with a bank as a fixed deposit for 2 years term, earning interest @ 10 per cent p.a. After the lapse of 6 months, Mr X is in need of 500,000/- to fulfil some of his urgent requirement.
At this juncture, Mr X has no surplus money and he would require a lead-time of about 5 months to accumulate the needed amount i.e. 500,000/-. In above kind of situation, what possible options are available to Mr X? Somebody may suggest the simplest appearing option i.e. Mr X should prematurely break the fixed deposit in order to fulfil his urgent requirement.
However, here we are missing one important point here. It may be noted that premature encasing of FD on one side may invite some monetary penalties imposed by the bank, while on other side; the interest will stop accruing on the full amount i.e. 1 m/-. This is against Mr X’s immediate requirement of 500,000/- and not to the extent of the full FD amount.
Appears to be a difficult decision on the part of Mr X, isn’t it? No! It is quite a simple decision if one diligently follows the key principal i.e. ‘borrow short while lend long’. By taking a cue from this mantra and as a practice, Mr X should try hard to keep his borrowing period as short as possible and ensures that his lending [FD] timelines to be the longest possible.
How can this be achieved? There are many ways through which Mr X can achieve the objective of borrowing short, while at the same time remains lending long. One of the options is to pre-maturely break the fixed deposit, take out 500,000/- from it and place the balance amount again under fixed term deposit with the bank.
Consequently, efforts should be made to re-invest the withdrawal amount by making regular investments @ 100,000/- for 5 months, as he is likely to create a surplus equal to this amount every month. The other option for Mr X is to keep the FD intact and take a short term loan of 5 months duration from the same bank.
This can easily be arranged on the strength of his fixed deposit, which can always be used as a collateral security with the same bank. Later on, concerted efforts should be made to payoff the loan amount in easy instalments - say @ 100,000/- per month and this is how the full loan amount [including interest] will get retired within a period of just above 5 months.
By doing so, what Mr X has ensured that his lending [FD] is far longer [both in terms of quantum as well as in period i.e. 2 year fixed deposit of 1 m/- ] than his borrowings [which is 500,000/- for about 5 months]. In simple terms the net result of this exercise would lead to an overall enhancement of Mr X’s asset [by earning interest of FD], while containing his liabilities.
But the important point which one should always keep in mind while executing the 2nd option [i.e. Keep the FD for 1m/- intact and borrow 500,000/- for five months], is on the role played by the prevailing interest rates as applicable for lending, and borrowing.
As per the market practices, the bank’s lending rate is normally higher than what banks pay on the deposits taken from various customers. The spread between these two rates is the net income of a bank. That being the case, it will not be wise on the part of Mr. X to keep his FD intact which is accruing interest @ 10 per cent p.a, while take a loan from the same bank at a borrowing rate of say 15 per cent p.a.
Therefore, the role of prevailing interest rates is an important determining factor under both circumstances i.e. either while lending or depositing your money to an entity, and equally while borrowing money from some external source. Notwithstanding the above, the substance of our today’s money mantra i.e. ‘borrow short while lend long’ remains intact.
Additionally, it also teaches us a new lesson implying – ‘borrow low while lend high’. This means that one must try hard to keep the spread between the lending, and borrowing rates in one’s favour.
This can be achieved by finding investment opportunities which can offer a reasonably high rate of return, while in case of need search for options under which one can borrow at a comparatively lower rate of interest. So as far as possible one must strive hard to remain in the category of “earning interest” and ‘not paying interest’.
This is the only way to maximise one’s assets and reach to the goal of “Financial Independence”. Take loans only when it is needed most, and never allow your money to remain idle but to always earn interest for you. Cheers!!!