Sunday, November 04, 2007

Personal Finance Part 4 - Good Debt Versus Bad Debt

In today's Sunday Times, there is a very good article in the Invest section which talks about the concept of good debt, and bad debt. This concept has been discussed in forums such as Wallstraits.com (see link on my sidebar) and Mr. Dennis Ng of Leverage Holdings Pte Ltd has also promoted this concept as being central to growing one's wealth. The article basically talks about how the number of undischarged bankrupts continues to hit new highs, meaning people are spending money which is meant for the future. This linked to the concept of good debt versus bad debt, as the author mentioned that credit card debt (which carries an interest rate of 2% per month or 24% per annum) is "bad", while other forms of debt which carry a lower interest rate may be deemed "good". Let's go into a little more detail.

Good debt is debt which boosts personal wealth and cash flows, and this would include debt taken to for example finance an education (a Masters degree perhaps), or to start a business. Everyone can understand the concept of taking a loan to start a business, as most people may not have the initial capital required to start a business. It is a form of debt which helps you to grow your money (assuming your business does well), and is similar to building knowledge and wisdom through studies, which is why such debt (study loans) can also be classified as "good debt". Bad debt, on the other hand, are debts which involve loans which are not sustainable or affordable; this includes credit card debts and debts from gambling (call it loan shark debt if you will !).

I fully agree with this concept as I feel that I am able to grow my money better than prevailing interest rates, thus I go for "good debt" over bad. An example is my housing loan which I pay 2.6% per annum HDB concessionary interest rate on. It would be silly to use my CASH to pay off this debt quickly as I am currently earning dividend yields of between 5 to 7% on the cash I invest in equities, which is almost 2.5 times higher than the interest rate on my HDB loan. Thus, I stick to using my CPF contribution to deduct against my home loan, as the interest rate on the Ordinary Account is only 2.5%, which is 0.1% lower than the HDB loan rate. Also, I avoid all credit card debts by paying my full balance promptly and also avoid borrowing money to invest in shares as this represents a form of leverage (margin) which means I may be subject to a margin call if short-term price changes dictate. This would violate my principle of capital preservation.

Another point the article makes is for us to examine why we are taking up a particular debt, to see if it makes financial and common sense to take up the loan; and also to assess if we have the ability to pay if back. I had considered taking up a car loan for a car some time back, but considering the running expenses (including ERP, parking, gasoline etc) can come up to more than S$1K a month, I decided against it as I figured I could not afford this kind of "debt" and commitment. Thus, one must ask oneself if you can afford to service the debt, assuming the worst case scenario (e.g. losing your job).

Interest rates are another factor to consider when reviewing loans. In Dennis Ng's interview, he gives an overview of the broad interest rate levels for various types of loans. Housing loans come in at 3-4% per annum (HDB concessionary rate is 2.6%), car loans 6%, renovation loans 8%, loans from GE money 20% and credit card debt 24% ! Thus, logically speaking, one should clear the debt with the highest interest rate first (i.e. credit card debt) before moving on to clear other forms of debt. The article gives an example of a PR practitioner Ms. Wee Hwee Leng, 28, who used to roll over half her credit card balance of S$2,000 per month, thus incurring hefty interest charges along the way. A friend taught her to be wiser and she has since paid off the balance in full and saved on all the interest charges which represents the cost of using "future money".

To summarize, I believe that most youngsters nowadays (i.e. those who just started working) prefer instant gratification rather than delayed gratification. In the words of Ms. Wee, she feels that she deserves to be pampered and most people who abuse credit cards also have this mindset, which leads to debt spiralling out of control. If we can adopt more "good debt" rather than destructive "bad debt", then we can move faster toward growing our wealth and achieving financial freedom. Comments are most welcome for this post as I am interested in readers' opinions too.

Note: For an alternative point of view on "good" and "bad" debt, check out this posting on kleer's blog. He does not believe in the concept of "good" and "bad" debt and considers all debt as "bad".

10 comments:

Anonymous said...

Hi, it is a good article indeed.

An alternative view i can come up with is, sometimes while true that investments can give higher yields (ie you not only enjoy interest free loans, u earn a 'dividend'!) but those are subjected to risks. Some investors may not be good enough to take advantage of a bull and bear market, especially the latter. Will they get the usual yield? Maybe not. Can u guarantee the yield will always stay above 5%? you cannot. But, what I can guarantee is, if I pay my housing loan in full, I own the house. That piece of mind knowing my roof is fully mine, can be worth more than what investments can bring.

I believe strategies should change with the times. If times are good and yields are good, why not take the loan. But when times are not too good, why not settle the debt if you can. Some will say, heck I should dump the money into the stock market and buy cheap. True, but investments should be made with money you can afford to lose. That money you set aside for the loan, can you afford to lose it? If no, then it should not be a sum of money used for investment.

Anonymous said...

MW,

I think to each his own, I guess. It all depends on the skill of the individual investor. Not forgetting that one is required to take out a (reducing?) term insurance on the house, so trying to pay off as quickly as possible does not make too much sense to me if one is able to generate better returns.

If the houseowner pass away one month after hurrying to pay it off, it is actually "quite a waste" cos' his family could have gotten the house for "free" due to the term insurnace requirement throughout the life of the loan period.

If one is able to generate better returns (in excess of 20%-30%), it is better to invest/trade with the CPF portion in individual stocks.

I guess in my case even though I have enough money in my OA to pay off my outstanding loan, I would rather use it to trade/invest in companies which I have spent alot of time analyzing.

It has worked out well for me this year cos' I have managed to use the investible part of the CPF money to generate another 30months of mortgage instalments.

Of course, it would be a dumb idea to "buy and hold" cos' even the best stocks will fall if a correction last long enough and deep enough.

For those who do not know how to invest/trade like MusicWhiz, this might not be a very good route. Or maybe just use the money to buy whatever he is buying ;-) ??

Just my 2 cts worth of random thoughts.

Have a good one.

Regards,
MM

musicwhiz said...

Hi charlesming,

Good points there which you made. It is true that investors may not always enjoy yields higher than inflation rates when they invest, thus they should pay down the loans if they fail to achieve this desired yield. Also, as you say, the peace of mind which comes with OWNING a house cannot be measured in monetary terms.

You are also suggesting adapting to the times, which means paying down the loan in "bad times" where you cannot find good interest rates or ways to increase your returns. I think that's a good idea, but it can be tough to properly define "good" and "bad" times, unless you use the economy as a benchmark. Most REITs will give decent yields of about 4-6%, which are higher than inflation already. I think this may be a safe place to "park" money unless the yield really falls to abysmally low levels. What say you ?

Cheers, Musicwhiz

musicwhiz said...

Hi MM,

Thanks for dropping by and sharing your experiences. Wow 30 months worth of mortgage payments :) That's a very good return ! You are being modest hahaha...

Yes, people should invest in products which can at least cover inflation (i.e. earn 3-4%) if they do not know how to invest or trade on their own. The worst would be to think that your money "grows" in a savings account. Of course, I have also commented on delegation (passive investing) versus active monitoring in my previous post. It is up to the individual how involved he wants to be, and I believe the returns will be proportional to how committed you wish to be about your own money.

Regards, Musicwhiz

Anonymous said...

Well in a bearish market, there could be good buys. Some may choose to go with 'cash is king' still. In this case, having my roof over my head which i call my own. No right or wrong. It really depends on the comfort level of each individual. No 1 correct way of doing it :)

Another way I came up with was to open a bank account in australia to park money there. The forex rate is high but their interest rate is also high. At around 6% plus. New zealand seems higher but i dont really go there. So that's another way.

I was in suntec reit. Not the best performing reit indeed so I got out of it.

Sorry for leaving out my name earlier. You're quick to note what I wrote on the other end. Kuddos!

--charlesming

fishman said...

Hi all,

Would like to share my thoughts on the idea of good vs bad debt.

Back when the only tools of financial management that I knew of were insurance and fixed deposits, paying off the mortage asap really seemed like a very wise choice. But today as my knowledge and understanding of the different types of financial management tools available, paying off the mortage suddenly seems like a very silly idea! So I think an important consideration is depth and scope of knowledge one has, as well how comfortable one is with more volatile instruments. If I invest in options, but every night dare not sleep and worrying I might lose money needed for mortage, I might as well place the money in fixed deposit or pay off the mortage?!

Another point to consider is that though HDB concessionary loan is quite low in interest rate, the actual interest amount that one has to pay can be quite significant because the loan principal is usually quite huge! And drag this over 30 years, I think the amount can be quite scary! Rememeber Buffett's favourite principal of compounding!

Just my thoughts. I agree that there's actually no right or wrong, just which is most suitable on an individual basis.

cheers!
fishman

P.S. Hey Musicwhiz, any insights into the Sembmarine episode? I think the recent quarter report really shows low transparency in management. What you think?

musicwhiz said...

Hi charlesming,

Yes, cash is king and I agree with that. Even though one may not be able to compound cash as one desires, but it is a good feeling to be debt-free. I have visited Vietnam and the people there are mostly free of debts and obligations and they are a much more carefree lot ! Of course, they may have other problems which we don't know of but mortgage loans clearly is NOT one of them. :P

Parking money in a foreign currency account is a good idea but the only issue is liquidity and forex risk. Cambodia banks pay an FD rate of 9.65% p.a. for junior (child) accounts. I am not sure what the rate for normal accounts is.

Suntec REIT admittedly is not the best performing but I just park my money there for yield. Perhaps when the circle line is up, I can see more appreciation ? Let's wait and time will tell. :)

Regards, Musicwhiz

musicwhiz said...

Hi fishman,

Yes, now the available investment products in the market are mind-boggling ! I was just looking through equity-linked notes to try to understand the mechanics but it can be confusing with all the terms. Thus, I still stock to equities which are more long-term in nature. ELN, CFD, covered warrants and options all have a shorter lifespan and are subject to much volatility (and stress !).

Actually, the HDB rate is one of the lowest in the market and even though the interest amount is high, you can argue that if you can generate returns of more than 2.6% p.a., then it is a "good loan" to keep. The principle of compounding works for savings, not mortgage loans. In fact, this is a reducing balance loan because the interest amount is reduced each time you clear part of the principle, so it works opposite to compounding !

For Semb Marine, I reserve my comments till full results of the investigation are made public. It will not be nice to speculate when the facts are not clear; but I do agree that so far transparency is wanting !

Cheers, Musicwhiz

Anonymous said...

Say you have two loans, one big amt, say $500K @ interest of 4.5% and one smaller $50K at 5.5%. The former incur interest on $22.5K while the later $2.75K - which one do you priorise to pay up first?

musicwhiz said...

Hi,

That would depend on whether I have a repayment scheme for the larger loan already, for example HDB loan is already getting "cleared" every month through CPF, so we can concentrate on the smaller loan with higher interest rate. There is no right or wrong I guess, it just depends which you choose to cleaR off first.

Regards, Musicwhiz