Good Debt vs Bad Debt

 

A lot of people think that if you want to be financially free then you should be free from debts too. They are right to some extent, if you are free from the debts then whatever extra cash that you have can be used solely for investment. This is an ideal situation.

Unfortunately the world is not an ideal place, most people in their quest for zero debts will have no excess (or very little excess) left to do any investment to generate passive income. Most of their cash are locked up in their house and cars.

So, not unlike cholesterol there are actually good debts and bad debts.

 

In general, any debt that has lower interest rate than your investment return is a good debt.

Let's say you have a housing loan debt of RM200k. Life is hard and you can barely make ends meet. You have very little savings. Unexpectedly your long lost aunt died and left you $200k.

 

Your housing loan interest rate is 6% p.a. Unit trust gives a consistent return of 8% p.a.

Should you settle your housing loan with your windfall? Or should you invest in unit trust and use the return from the investment to partially support the loan instalment?

The logical choice is of course the latter because the housing loan is a good debt so why do you need to settle it?

Some of you may disagree and would prefer a "peace of mind" over common logic. You would rather pay off the debt so that nobody can take away your house. That is a fairly good reason actually.

My challenge is what if the economy turn for the worse and you lost your job? Your cash are now tied up to the house which cannot be easily liquidated most especially during economic downturn.

On the other hand, if you were to choose the second option, you will still have the $200k that generates 8% return per annum. Even if you lost your job you can still easily service the loan using the money and feed your family while searching for an alternative employment.

Another common reason why people in the above scenario will tend to fully paid the loan is because they are worried that they will spend all the money and ended up neither here nor there. Still in debt and have no savings either.

This is a bit tricky. There is no magic formula to cure lack of discipline unfortunately. Even the best laid plan will go awry if there is no resolve to follow it through.

 

Emergency fund should not be touched in any circumstances except the loss of employment. Investment fund should only be withdrawn for the sole purpose of reinvestment.

So before you go on this journey, it is imperative to make sure that you have a strong will to carry it through. Shaky resolution will get you nowhere.

Let us revert back to the example. What if the housing loan interest rate is 6% p.a. but the cash-like investment can only give you a consistent return of 4% p.a. or lower?

Under these circumstances the debt can be considered as bad debt. If we were to consider only the obvious then by right you should use the inheritance to fully settle the loan.

However, since you don't have any emergency fund I will not advise you to fully settle the loan. Maybe set aside some money for emergency fund and use the rest for partial settlement.

Please note that this is just a simplified version of the real world. In the real world, life is not that black and white. It is rarely that straight forward.

 

Situation changes all the time. Maybe due to some changes in the investment climate, the unit trust fund may give more robust returns in future years.

I still remember the time when interest rates for housing and car loans were sky high back in mid and late 90s. Now they are quite low. It might change again in the future so good debt today may be bad debt tomorrow.

The key is to be vigilant and take action appropriately depending on the situation.

 

Homework: Go through your current debts. Determine whether they are good or bad debts. If they are bad debts, how fast can you pay them off? Devise a plan and take action!

Interest Rate

 

"An interest rate is the rate at which interest is paid by borrowers for the use of money that they borrow from a lender. Interest rates are normally expressed as a percentage of the principal for a period of one year." – Wikipedia

"The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). When the borrower is a low-risk party, they will usually be charged a low interest rate. If the borrower is considered high risk, the interest rate that they are charged will be higher." – Investopedia

A few key points to note:

• Expressed as a percentage of principal
• Noted on an annual basis
• Low risk, low interest
• High risk, high interest

Interest rates are always quoted in percentage form i.e. 8% p.a. P.a. stands for per annum which means that the loan carries 8% interest charge annually. So if you borrow only for half a year, the interest that you pay will only be 4%.

Some of you may wonder why you need to know all these. This knowledge will enable you to determine whether the debts that you have now is good debt or bad debt.

Some small business owners in my home town like to borrow money from unauthorised lender. They will borrow $1000. Everyday, the lender will collect from them $13. Since they deal with cash business, $13 per day is a small amount to them. After 100 days, they will borrow $1000 again and this will go on and on and on. Is this a good debt?

Let's do the math shall we? $13 x 100 days = $1300. That is 30% interest every 100 days! If we were to convert that to annual interest rate it will be a whopping 109.5%!!

Now you know why the ignorant gets poorer and the unscrupulous gets richer. You can't blame the opportunists fully when you are so happy in your ignorance can you?

Compare that with what the bank charges. You can get personal loan (no guarantor or collateral required) for 14% - 42% per annum. If you are a Government servant, you can get it for as low as 6.04% per annum!

You can do the comparison of the personal loans offered by Malaysian banks here: http://www.imoney.my/personal-loan

This is where I would like to draw your attention to the last two key points below:

• Low risk, low interest
• High risk, high interest

This is why you need to have a good credit standing. This is why I emphasise paying your debts on time every time. Generally the loans offered by the banks will have a range of interest rates. For personal loan above the range is between 14% - 42% p.a.

If you have a good credit standing, the bank that offers 14% p.a. will be happy to accept you as their customer. If you have a lousy one, even the bank that offers 42% p.a. will shut its door to your face. Then you will have no choice but to get the 109.5% p.a. loan.

Can you see the difference? Ignorance will cost you money. Your lackadaisical attitude will have serious repercussion.

Another thing to be aware of is the quoted interest rate may not be the real effective rate. In Malaysia, this normally applies to car loans and personal loans. This type of interest rate is called flat rate.

A flat interest rate is an interest rate calculated on the basis of the stated initial principal amount of the loan irrespective of the payment plan.

Let's say you borrow a car loan of $60k at interest rate 3% flat for a loan period of 5 years.

How the bank calculate the interest: $60k x 3% x 5 years = $9k.

Total debt is now $69k. Monthly instalment will be $69k/60 months = $1150.

The bank will charge you the full interest amount of the initial loan even though the debt is reduced over the years. Is this a good debt or a bad debt?

To do the comparison, you need to know the effective interest rate. As a general rule, flat interest rate is double the effective interest rate. In this case the effective rate will be around 6% p.a. Is it a good debt or still a bad debt?

Flat interest rate have been outlawed in developed countries. However, they persist in many developing countries, and have frequently been adopted by microcredit institutions.

If you were to go on the link I provided above, you can see that the flat rate of 7.62% is equivalent to an effective rate of 14% p.a. So be mindful of this when you do your opportunity costs analysis.

Lucky for us that for our single most expensive purchase, the housing loan is quoted in effective interest rate. You need to be aware however, whether the loan is of daily rest or monthly rest basis.

I know it may seem tough to know all these finance stuff, but it is really not that difficult.

Below is a simple diagram to explain the difference between daily and monthly rest. Outstanding loan on 1st April is $100k. You made capital repayment of $30k on 20 April.

 

If your housing loan is on daily rest, then from 20th April onwards your interest calculation will be based on the outstanding loan of $70k.

If your housing loan is on monthly rest, from 20th to 30th April you will still be charged interest based on the outstanding loan amount of $100k even though you have paid $30k on 20th April.

Not that difficult right? So be aware of this small detail before you sign on the dotted line.

With a myriad of offerings by the banks and the banking sectors constant innovation, it is quite impossible for me to cover everything in this book. Do some researches before you commit yourself.

Sometimes they hide the "interest" element under terms like "profit sharing", "admin costs", "exit penalty". So be mindful of those hidden charges when you do your analysis to determine whether the debt is good or bad. Have fun!

Credit Card - The Villain of the 21st Century

A lot of people associate credit cards with evil. The much maligned credit card will be the first to be burned on the stake when people seek to provide example of bad debts.

A lot of people also use the fact that they don't use credit cards as some sort of a "badge of honour" when talking about good financial practice.

Are credit cards really the villain of the 21st century?

Recently there is a new kid in town called debit cards. There is a lot of hype about debit cards as more and more people are into cashless shopping, and many more are less inclined to shop on credit.

Are debit cards really the knight in shinning armour?

I'm not going to explain about credit and debit cards here. Neither am I going to do a comparison between those two and declare a winner.

Enough have been written by others of the pros and cons of both. I have provided some links at the end of this chapter if you are interested to find out. I recommend that you read all of them. Those are very short and straight to the point articles. Then you can make your own decision.

Coming back to the issue on hand. Are credit cards the source of all evils?

Personally I think credit card is one of the best modern inventions.

Who will allow you to buy stuff and use them for a month before asking for payment? Their 0% easy payment scheme even allow you to spread the payment up to 6, 12, 24 months without incurring any extra costs. Their points system will reward you with free stuff without doing anything extra!

I think credit cards are awesome!

A lot of people blame the credit card when they cannot get out of self-made debt-hole. It is always easier to blame others for your own weakness.

As I mentioned earlier, there is no magic formula to cure lack of self discipline. Even the best laid plan will go awry without the strong will to follow it through.

The key to a successful relationship with your credit card is to make full payment on time every time. Never ever be tempted to pay less than the full amount. 

Another thing that is not so well known about the benefit of a credit card is their "balance transfer" promotion. Sometimes when a bank wants to steal customers of other banks, they will offer 0% interest for the balance transfer to be paid within 6 months.

What this means is if you buy stuff using credit card of Bank A, Bank B will pay your debt in full to Bank A and allow you to spread the payment to Bank B for 6 months without even a single cent extra. How awesome is that?

I admit that I have used this facility twice and bought a lot of designer handbags. All fully paid and does not even incur a single cent extra than if I were to buy them using cash.

As for debit cards, frankly I have no strong opinion of them. I have a great love relationship with my credit card for close to 20 years that I cannot see any reason why I should try something new.

Why change something that is not broken? 

Credit cards may be the villain of the 21st century for some people but to me they are my knight in shinning amour. I simply love them! I truly cannot imagine life without them.

Things you should know about Debit Cards:
http://www.imoney.my/articles/secrets-of-getting-and-maintaining-a-debit-card/
http://www.imoney.my/articles/now-you-can-spell-convenience-with-a-debit-card/
http://www.imoney.my/articles/debit-card-what-is-it-how-does-it-work/
http://www.imoney.my/articles/about-debit-card/

Debit Card vs Credit Card:
http://www.imoney.my/articles/debit-card-vs-credit-card/
http://www.imoney.my/articles/debit-card-vs-credit-card-2/