Our government’s recent announcement of its plans to issue money-lending licenses to developers has been taking a lot of political flak. I’ll leave it to others to discuss on the socio-economic aspects of this silly move but I’d like to take a minute to study the legal-mathematical aspects of this.
Sec 6 of the Act requires that the license be issued out only to individuals, partnerships, and a registered business. Money lending licenses cannot be issued out to companies. Most developers are incorporated as companies. So, if any developer wishes to take a money-lending license, they would need to use a different entity.
The trouble with not using a company is that of taxes. Any income derived from this money-lending activity will be construed as individual income and will be charged at the highest rate of 28% considering the amount of money they will be lending out.
Some developers may not like the idea of paying such an exorbitant tax rate but that’s completely up to the developers.
Sec 5D of the Act says that the Registrar (not the Minister) has the power to attach any number of conditions to the license granted. That’s why the Minister claims in the article that he has the power to set the maximum interest rate at 6% instead of the 12%-18% limits as stated under the Act. In actual fact, it’s the Registrar who has the power.
Sec 17 of the Act says that interest can only be calculated in a simple interest method as compound interest is prohibited. This is something that lots of people have missed out on in their criticisms of the decision. I know that lots of lawyers are not very good with math, so I’ll try to explain it.
Simple v Compound
Simple interest is calculated linearly. What this means is that the amount of interest incurred, increases proportionally with the duration of the loan. Compound interest increases exponentially with the duration of the loan.
I generated this plot from two different calculations, the straight line one is the simple interest at 6% and the one curving upwards is compound interest at 5%. From this plot you can see that the intersection is at around 8 years.
What this means is that if a borrower had a choice to take a bank loan at 5% or a developer loan at 6%, they would actually pay less interest to the developer than to the bank if the duration of the loan was 8 years or more.
However, this hides a very important question – where is the developer going to get the money to lend to the borrower? Since most developers are highly leveraged, this means that they do not have the cash to hand out to the borrowers. In fact, they’re probably going to have to borrow money from the bank in order to lend it to the borrower.
Granted, the developer could probably negotiate a pretty low interest rate from the banks but the base-rate set by Bank Negara is between 3%-4.25% and they cannot go lower than that. This means that there is still an intersection, just at arond 20 years instead.
This plot shows that the developer can make a profit from lending at 6% on a borrowing of 4% right up to around 20 years. After that, the developer actually pays more interest to the bank than the amount collected from the borrower.
This seems to indicate that there’s a sweet spot for these developer loans – between 8-20 years – to turn a profit for the developer and pay lesser interest for the borrower. So, from a purely legal-mathematical perspective, these developer loans do make some sense for both the developer and for the house buyer.
There are many other financial factors not yet considered for this e.g legal fees etc. Of course, there is the whole other socio-economic aspect on how such a move may be detrimental in a country where the household debt is already really high. Also, this move will continue to drive up housing prices and will probably contribute to a property bubble. There’s also the moral hazard that is presented when the developer serves as the lender.