Good Debt and Bad Debt

Nov 4, 2007

Handled well, debt can boost wealth and even cash flow. Lorna Tan of The Straits Times, offers tips on making debt work for you

ENJOY now, pay later.

This seems to be the carefree philosophy of countless big spenders in Singapore who rely on credit to fund their shopping sprees, vacations and wedding celebrations.

It might also explain some disturbing statistics that suggest many people are losing the battle with credit. For instance, the number of undisclosed bankrupts in Singapore has reached a record high of 25,500.

And another record: There are 5.45 million credit cards in circulation, weighed down by rollover credit card debt of $2.81 billion as at end-August. In fact, the figure is slightly lower than it was in June, when the rollover balance hit a record $2.87 billion, according to the Monetary Authority of Singapore's website.

To put it bluntly, many Singaporeans are still paying for meals they ate months ago and holidays that are now almost forgotten. And the trend is set to escalate as credit becomes more and more readily available, even to those with lower incomes.

Banks recently won the right to issue credit cards with a $500 credit limit to those who do not meet the usual minimum annual income requirement of $30,000. Moreover, an estimated 450,000 people who earn between $20,000 and $30,000 a year will soon be able to borrow without collateral from banks, although they will not be able to apply for credit cards.

Types of debt

NOT all debt is bad, say financial experts.

Mr Patrick Lim, the associate director of financial advisory firm PromiseLand Independent, says that 'good debt' tends to boost personal wealth and even cash flow.

To GE Money Singapore president and chief executive Iqbal Singh, good debts are loans incurred to generate positive returns or create value over time, through increasing one's earning capabilities and/or income.

GE Money gives loans to those earning less than $30,000 a year.

'For example, debts are good when used for purchasing assets or a house that will appreciate in value; and for education, as additional skills and qualifications are likely to increase one's earning ability,' says Mr Singh.

Debt is bad when it involves loans that are not affordable or sustainable, or when it is incurred for the wrong reasons - such as gambling. When a person stretches himself beyond his means, overspends and is unable to settle his loan repayments, the debt is considered bad.

He lands himself in a debt trap when late payment charges pile up, causing the debt to grow even bigger.

Loan considerations

MR KUO How Nam, the president of Credit Counselling Singapore (CCS), says that people should 'think very carefully' before borrowing.

Any sum borrowed has to be paid back from future income and anything that affects future income will affect one's ability to pay, he notes.

Before you take on any new debt, you should consider the following points.


1. What is the purpose of the debt?

Ask yourself if the loan is for consumption or investment purposes.

If you plan to indulge in an expensive car, the loan might become an unsustainable bad debt.

But if you want to pay for further studies that will boost your future earning prospects, it could be considered good debt.

2. Can you really afford it?

Carefully consider your other monthly payment commitments, both fixed and variable, before taking on new debt. Look at how much you will have to pay in total after you add the proposed new loan instalments to your existing commitments. Then ask yourself if you are still comfortably within your disposable income level, said GE Money.

Mr Kuo says a borrower must also examine how is he going to pay back the loan - in other words, he must assess just how secure his future income is.

Take the case of Mr Ronald Lim, who approached CCS for debt restructuring assistance when he was unable to service his loans. When he got married, he decided to stretch his finances and spent nearly to $100,000 on home renovations and a lavish wedding reception. His monthly salary was $3,000. After exhausting his savings, he ran up even more debt using his credit cards.

3. How are you going to repay the loan?

If the loan is to be serviced by both spouses, they must weigh the consequences should one spouse lose his or her job, or decide to stay at home to look after the children.

Said Mr Kuo: 'Some people find themselves committed to a lifestyle that requires two incomes.'

4. How high is the interest rate?

If the interest rate is 24 per cent a year, the standard rate for unpaid balances on credit cards, then forget it - this is not an option. There are cheaper alternatives. For instance, at GE Money, the monthly instalment for a $7,000 loan over three years is $260.

5. Do you understand the terms and conditions of the loan?

Some customers are not aware that when promotional interest rates are offered - say, 3.99 per cent a year - to customers who roll over their credit card balances, the offer is good for a specific period only. Once the promo is over, the rate reverts to the higher 24 per cent rate, the standard rate imposed on outstanding card debt.

6. How steady is your income?

If you earn a commission-based salary, your future income stream might be unsteady, so you have to be more careful when assessing your ability to service the loan.

7. What portion of your income goes to your debt?

Mr Kuo suggests that debt repayments should not exceed 25 per cent of one's income; otherwise, servicing the debt might become painful. If the loan is being serviced by both spouses and one becomes jobless, the other will have to take over the balance of the loan, so the debt to income ratio will double.

8. What happens if you cannot pay?

Just about the worst thing that could happen if you default on a loan is that you could be made a bankrupt.

Mr Leong Sze Hian, the president of the Society of Financial Service Professionals, who is a volunteer at the Official Assignee's office, cites the case of an HDB flat owner who was made bankrupt by the HDB for not paying his HDB mortgage, even though the HDB is generally seen as taking a gentle approach in these cases.

Getting out of a debt trap

MOST experts advise clearing debts with the highest interest first. At the top of most lists would be credit card bills, which if left unpaid could easily double within a few months and lead to spiralling levels of debt.

However, if you are in danger of defaulting on, say, your home loan, keeping up your repayments for that might be more important than clearing debts with higher interest rates.

If you default on a housing loan, you might lose your home and face bankruptcy.

Borrowers should also consider other factors such as whether the interest rate is fixed or variable.

In addition, they should look at default interest rates and termination fees.

'We advise debtors to settle debts with variable interest rates first. These will bring greater certainty about the size of the debt and thus help facilitate debt-clearing plans,' said GE Money's Mr Singh.

Mr Scott Mitchell, a senior vice-president with ipac financial planning Singapore, advises maintaining a savings plan while paying off debts.

'Many people concentrate on paying off their debts before starting to save, or they will shelve their savings plan altogether.

'You should always save a portion of your money on a regular basis while you pay off your loans; this cements good saving habits,' he said.