Whether you are a professional such as a lawyer, accountant, doctor, running your own successful business or a regular salaried worker, the question of how much and what kind of debt to take is inevitable. Done properly, debts can help you build a strong leverage position to exponentially grow your monies, while it can also push you into bankruptcy in the blink of an eye if you carelessly take up debts without understanding the true implications and risks involved. In this article, we will examine the various debt related pitfalls that many tend to fall into, and learn what strategies we could possibly employ to spend our monies in a more prudent and financially efficient manner.
One very common mistake people make is falling into the credit card debt trap. Especially for those who had just begun working, there will be temptations to immediately indulge in luxuries to pamper yourself or reward yourself for the hard work that you do. Credit cards offer an easy way to spend a multiple of your income, and many people only end up paying the minimum monthly fee to sustain their debt in order to free up more cash to then be further spent. Racking up credit card debt in this manner for a year or two may still be salvageable, but things will soon spiral out of control for one simple reason: High compound interest. Credit cards usually charge upwards of 20% interest rates per annum for any outstanding debt. Couple this with credit card fees (although these are sometimes waived) and this amount compounds to frightening figures after several years if left unmonitored. Even with access to credit cards for easy borrowings, it is generally advisable to exercise caution and wisdom in expenditure, and limit your credit card debt even if you are unable to pay off it off every month; maxing out your card (or cards) regularly is highly likely to lead to an unpleasant financial mess in the near future.
Now let us consider another scenario: You are advertised a car loan rate of maybe 3-5% per annum, which is a rather sustainable rate of interest payment for general cases. This quoted rate is what you would call a nominal interest rate in finance, but since interest rate for car loans are charged on the principal amount (the original loan amount) as opposed to whatever outstanding amount you have at each point in time, if you took a loan of SGD 100,000 at 4% nominal (assuming no other processing fees) to be paid over 5 years, your effective rate is in fact approximately 7.42% per annum (that is a 3.42%-point difference from the quoted 4%). Even if you took the loan to free up monies for investments, chances are any profits from your investments would be eroded away by the high interest rates from the car loans.
The point to note here is that even if you can afford the monthly payments for a car loan, you should refrain from splurging on a vehicle (or at least try to reduce your loan amount) unless you have sizeable excess cash reserves. Specifically, in Singapore, the COE system results in value of cars depreciating value faster, which further reduces the appeal of having your own vehicle. Owning a private transportation vehicle does aid in ease of convenience and to some jobs might even result in an increase in productivity, hence discussing your specific situation with a finance professional that you can trust is generally the advised course of action prior to making any decisions on this matter.
As you can see from the above, loans are offered in various forms, and you should request for the effective interest rates as opposed to the marketed interest rates if possible, as these offer the most accurate depiction of the rates that you are being offered. Each loan agreement might also come in varying terms and conditions, and it is advisable to look through the agreement before putting pen to paper as two loan offers with similar effective interest rates could also differ in terms of attractiveness based on the differences in how the loan agreement is drafted.
As a general guideline, you should try to keep your Debt to Asset Ratio (given by Total Liabilities over your Total Assets) to below 50%, this ensures that you generally do not take up too much debt in totality, the flaw here though being that it does not discern from low interest or high interest debts. However, monitoring your Debt to Asset Ratio is still an important part of debt management.
If you have any debts which interest rates are higher than or even hovering close to the rate of return that you can get from your investments, it is generally a good idea to clear off those debts as soon as possible. Some examples of these kind of debts are car loans, credit card loans, unsecured personal loans etc. Conversely, if you have loans which you are paying relatively low interest for, you can leverage on the loan amount to invest and grow your monies much faster than if you were to directly invest that same sum of money from your own pocket. A popular example of low interest loans used for leverage are mortgage loans, and this ability to leverage is one powerful reason why many people favour property investments. Do note that leveraged investments do have their risks and limitations as well however, and should not be ventured into without proper advice and prior knowledge of the full benefits and limitations of the strategy.
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