Countless articles have been written on investing, debt, expenses, and liabilities. Most of them have explained the concepts superbly, but failed to awaken the reader's curiosity.
Let me try today to explain an investment's outperformance over a liability using easy-to-understand math.
Let us start with some basic definitions...
Investing is the process by which you are parking a portion of your active income in vehicles that could build you an asset over a defined period.
Debt is the process of borrowing money from a person or a bank to fund an immediate expense. This borrowed money must be repaid with interest over a defined period.
Expenses are the costs incurred for buying the items you choose. If you want to enjoy a fine ride, you would have to spend money on it.
Income is the amount of money you get in exchange for your services. If you have a job, the salary you get is the income for the time, effort, and intelligence you have put into it over the course of a month. Income can also be generated from assets.
Assets are things that generate income for you. The income from assets could be active — like a job, or passive — like from investing.
Liabilities are things that create expenses for you. An example is a car loan, as it mandates monthly instalments until it's cleared.
The Asset cycle can originate from any specific point and keep running continuously. For example, investments can create assets, which then create an income. Similarly, Income creates investment opportunities, which in turn create assets.
The Liability circle also works the same way. An expense can create a debt, which creates a liability. Similarly, a liability creates an expense, which pushes you into debt.
The only link between these two cycles is the “Income” part. You have the choice whether to use it for investments or expenses. The choice you make fuels either of these circles. So, it all boils down to your choice.
Let’s add some math to make it make sense.
Assuming you have a monthly income of ₹1.5 lakh and wish to keep aside a sum of ₹30,000 every month. You could either invest this amount or pay it as an EMI on a debt.
Case 1: You are investing ₹30,000 for 20 years in a mutual fund that grows at an assumed rate of 12 per cent. The returns are an astounding ₹3 crore.
Case 2: You are paying an EMI for 20 years at an interest rate of 7 per cent. As per the figure, the exact amount you could borrow is ₹38.7 lakh.
The divergence is huge. If you had channelled ₹30,000 per month into the asset cycle, it would have grown to ₹3 crore, versus ₹38.7 lakh if you had chosen the debt cycle. The asset cycle's outperformance is a massive 7.75x that of the debt cycle.
The difference is mainly due to the time factor, which is an ally of assets and an enemy of liabilities. But for each cycle to kick-start, it required an initiation from your end, i.e., an investment or a debt of ₹30000 per month.
The writer is a SEBI Registered Investment Adviser (RIA), INA000021757, and author of ‘How to join the top 1% options traders club’.
DISCLAIMER: Mutual Fund investments are subject to market risks; read all scheme-related documents carefully.
The opinions expressed in this article are those of the author and do not purport to reflect the opinions or views of THE WEEK.