Many of us would have been told our whole lives, that owing money is bad.
But there are always 2 sides to a story.
The Big ‘D’:
We owe a debt when we spend money that we do not have. And unless our family is wealthy or we strike 4D, debt is something that most of us will inevitably have to incur. So, it’s important to differentiate between good debts and bad debts.
It is either used for purchasing items that have lower or no resale value or are not income generating, or it comes with high interest rates.
Let’s take a look at 3 examples.
Credit card debt: Notorious for their high interest rates (>26% p.a.). Singapore even had a new high in bankruptcy applications before the pandemic hit in 2020.
Buying items on Hire Purchase because of the low monthly payments: High interest rates (>12% p.a.) actually hide behind the affordable payments. In fact, a $3,000 purchase can snowball into $30,000 after just 8 years!
Leveraging for investing: Low interest rates may tempt investors to loan money (e.g. personal loan) in order to buy more shares. This is known as leveraging. But having a positive return is not enough. The ROI must also be able to cover the interest of the loan first before the investor can make any profit.
Good Debts:
Education loan: Generally, the more educated we become, the greater our earning potential. With interest rates averaging at a reasonable 4% p.a., taking a study loan to fund a degree can provide you with career opportunities that will repay it many times over.
Home loan: Although a home loan’s interest will add up to a hefty sum in the long-run due to the huge principal borrowed, its interest rate (>1.15% p.a. onwards) is actually one of the lowest compared to other types of loans. In addition, it is not uncommon for the property to appreciate in value well before the loan is paid off. This allows us to sell off the property with a net profit (after interest), that we can then use to buy our next property.
Business loans: There is now a wide array, from the traditional business loans, to SME loans, to small business loans.
The Grey Debt:
Car loan: Although the interest rates (averaging 2.5% p.a.) are considered low, it is not the same as the Effective Interest Rate (EIR) because car loans used a Flat Rate Method of calculation instead of a Reducing Balance Method.
Renovation loan: We cannot put a price on comfort, but with interest rates starting from 3% p.a., it is better to be mindful whether our renovations are for our own comfort or to impress others. Some of us may also be tempted to follow the trending designs instead of opting for a timeless design. We may then find ourselves wanting to renovate again when our once trendy home design has become out-of-fashion. Also, if you are planning to sell the house soon after MOP (5-10 years after you move in), it is wise not to spend so much renovating since you will not be living there long term.
Debt consolidation loan: It is perhaps the most viable option to help us reorganize and reduce our total debts so that we can pay them off faster. But with an EIR of 7%, it is technically still an expensive loan.
Protip:
Before we take on loans in the future, think about these 3 questions:
What is the purpose of the loan – Is it for consumption (bad debt) or investment (good debt)?
What is the repayment plan – Are the monthly repayments affordable? How long will it take to pay off the loan? How are the early repayment charges and late payment fees like?
Reading in between the lines of the T&C of the loan – There may be ‘hidden’ costs such as a processing fee, a min. monthly spending requirement, and even the loan affecting your Credit Score. Most importantly, the stated interest rate may not be the EIR.
The world of debts is complex to say the least. Because it is technical in both calculations and legal wordings. Hence, we strongly recommend that you seek advice from a professional, even if it’s just for a second opinion.
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