Good and Bad Debt
Posted by
Lemizeraq
Labels:
financial products,
how to save money,
warren buffett
Banks love customers who likes to roll their credit card debt by just paying off the minimum sum. Of course they love them, because these customers pay up to 24% interest on their maxed out credit cards.
Here in Singapore, the minimum credit limit given to a person with $30,000 a year salary (which is the minimum to qualify for a credit card) is $5000. I have seen people who mismanaged their finances and maxed out their credit card from different banks and pay just the minimum payment each month. Worse, they will even contrive to spend that amount they pay using the credit card on their 'consumerism'. If someone had sat down with them to calculate the amount they contribute to the banks' coffers, I think some of them will be astounded. $5000 maxed out credit card paying 24% means that they give $1200 to the banks each year. So the banks' 'platinium' or 'black' card customers should be these people as they pay annual fees of $1200 each year.
There is good and bad debt. Good? Yep, good debt is debt incurred to purchase an asset which will either yield a return on the capital (ie one million dollar house selling 5 years later for 2 million) or a regular return like monthly rent. This debt enables one to either become more financially stable or enable a company to grow. So this is the good debt.
When does debt becomes bad? Well, the credit card example is a prime example of bad debt. I would argue that in Singapore, the car debt is another example of debt which one should repay off as soon as possible. That is because the interest charged on the car loans, while not as high as that of the credit card, is higher than the returns that you can get from even an average returns on investment.
Before I bought a house from our 'beloved' HDB I had believed that the housing loan interest should be repaid as soon as possible. Two things made me change my mind. First, was a conversation I had with a older colleague who was on the verge of retiring. He told me that I should pay off the HDB loan slowly and keep the money that I would otherwise have used to pay off the housing loan for investments and as cash for emergencies. The rationale being if there was something untoward that happen to me, my family will be left with just one breadwinner. And since there was a mortage reducing insurance on the house, it meant that the remainder of the house loan will be paid for by the CPF board. So my family will be left with little money but a fully paid up house. I thought about it and the reasoning sounded logical so I decided to stretch the loan as long as possible so that I would have surplus in both CPF and take home pay to use for investment.
Here in Singapore, the minimum credit limit given to a person with $30,000 a year salary (which is the minimum to qualify for a credit card) is $5000. I have seen people who mismanaged their finances and maxed out their credit card from different banks and pay just the minimum payment each month. Worse, they will even contrive to spend that amount they pay using the credit card on their 'consumerism'. If someone had sat down with them to calculate the amount they contribute to the banks' coffers, I think some of them will be astounded. $5000 maxed out credit card paying 24% means that they give $1200 to the banks each year. So the banks' 'platinium' or 'black' card customers should be these people as they pay annual fees of $1200 each year.
There is good and bad debt. Good? Yep, good debt is debt incurred to purchase an asset which will either yield a return on the capital (ie one million dollar house selling 5 years later for 2 million) or a regular return like monthly rent. This debt enables one to either become more financially stable or enable a company to grow. So this is the good debt.
When does debt becomes bad? Well, the credit card example is a prime example of bad debt. I would argue that in Singapore, the car debt is another example of debt which one should repay off as soon as possible. That is because the interest charged on the car loans, while not as high as that of the credit card, is higher than the returns that you can get from even an average returns on investment.
Before I bought a house from our 'beloved' HDB I had believed that the housing loan interest should be repaid as soon as possible. Two things made me change my mind. First, was a conversation I had with a older colleague who was on the verge of retiring. He told me that I should pay off the HDB loan slowly and keep the money that I would otherwise have used to pay off the housing loan for investments and as cash for emergencies. The rationale being if there was something untoward that happen to me, my family will be left with just one breadwinner. And since there was a mortage reducing insurance on the house, it meant that the remainder of the house loan will be paid for by the CPF board. So my family will be left with little money but a fully paid up house. I thought about it and the reasoning sounded logical so I decided to stretch the loan as long as possible so that I would have surplus in both CPF and take home pay to use for investment.
The second reason is that the interest rate charge was a low 0.1% above the CPF interest given for Ordinary Account of 2.5%. So it is better to keep the money in the CPF account and invest it for a higher return than to repay it as soon as possible. Historically, the returns for investments in the stock market averages around 7.5%. Of course, the world renowned Warren Buffett can achieve a return since the 1960s of 15% per annum, but there is not many like him.
I once read that if you had invested around $10,000 with Warren Buffett when he first started his fund for investments, you would have been a millionaire by 1980s. As you can see in the table on the left, at 20% compounded returns from 1956, you can be a millionaire in 1982, a short 26 years. If you had stayed invested, you would have around $109 million.
So which would you rather have? 24% per annum paid to banks or to earn 15% interest on your investment?
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reliance placed on information provided in the blog.
Shares and financial instruments illustrated in this blog can go down sharply or in certain instruments suffer total loss on the initial investments. Investors are advised to make their own judgment on the information provided and consult their own financial advisors or consultants as to the suitability of the products illustrated to their particular financial needs and objectives before acting on any information contained herein in this blog.
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