Are all debts bad? This is a question that most people struggle to unravel. Truth is, not all debts are bad, some are actually good and can improve your financial situation. So, what are some of the debts considered good? Read on to find out.
Most Singaporeans believe that owing someone money is a bad thing. No one looks forward to giving away money; we all prefer to be given. However, life is complicated and everyone sometimes is faced with cash-flow challenges. It’s not just the low income earners, or unemployed people who find themselves requiring debt, but everyone even the rich; and this explains why even the high income earners prefer to finance their long-term projects like home ownership through loans,when they can pay cash? Fact is, not all debts are bad, some are actually good,it all depends on several factors that this article seeks to explain.
So What Constitutes Good Debt?
A good definition of a good debt is any debt that will generate more income in future,or in financial terms will increase your future net worth. Old economists say,it takes money to make money, and this is what good debt is all about. In simple terms, good debt s when leverage is used effectively.
Here is an illustration:
Consider that you borrow $2 M to purchase a house. The house is estimated to be worth 2.4 Remember the lender cannot finance you 100%, hence out of the 2.4 M required, you can only get 2M .If the loan duration is 30 years, and the loan interest rate is estimated to range from 1.7 to 1.9%.The estimated monthly repayments is estimated to be $7,500.Now is this a good or a bad deal?
Two people will look at this opportunity differently. To one, the $7500 monthly installment is a huge debt but to another, this is a cash cow. The good investor will take the loan, lease out the house and make an estimated $9000 per month (could make more money if the house is well positioned).If the investor who is now a landlord makes $9000 per month, he can pay off the mortgage monthly installment of $7500 and save $1500.
Now imagine the landlord sells the house after 30 years. Assume that after 30 years, the value of the house has appreciated to $3.5 Million. In this case, the investor stands to make a $1.1 million in profit (the difference between buying price and selling price). Also, the landlord will have earned rental income for 30 years. Assuming the house is always occupied (no vacancies), then in total,the landlord will earn rental income amounting to $540,000. Now, the total income the investor makes from the property is $1.6 Million. Is this good debtor bad debt? This is an illustration where two people view the same concept differently, one sees a 2 million debt, while another sees an opportunity to make 1.6 million dollars in profit.
In the simplest sense, a good debt should pay for itself.
Examples of Good Debt
As pointed out above,a good debt represents any investment whose returns exceed the repayments. Something needs to be clarified here, the return can either be long term or short term,and an investment may be an asset like property, shares, stocks, bonds or any other asset. Also, an asset can be tangible or intangible, like is investment in education an asset?
Study/Education Loans
Is investment in education worth it? Most people invest in getting quality education to build successful careers which can help them offset the education loan. For instance,someone can take a loan to finance a law degree. Well, law is one of the most expensive courses in Singapore, but the lawyer’s income is also one of the most competitive. Thus, even though you will incur debt financing your law degree,the income from your practice can enable you make the repayments within three to five years only.
Investment and Business loan
In the business world, taking a loan is inevitable. To start, expand, grow, acquire asset or to undertake any capital intensive project requires a loan. The business borrows the money on the assumption that the investment will generate revenue and payoff the loan. For instance, when you borrow to open a new branch, the new branch is likely to increase the profit margin, hence enabling you to repay the loan.
The same case applies for individuals who borrow a personal loan to undertake personal projects.For instance, if you borrow money to build your own home, you will save on monthly rent, thus the debt will be able to pay itself.
However, it is important to note that not all investments have a guaranteed return. For instance,sometimes a business idea will flop, and since you will have acquired the loan already, then you end up increasing your liabilities. For instance, sometimes an education loan fails to payoff, when after graduation, the market can’t absorb all the grandaunts due to oversupply of graduates.
Thus, to be considered a good debt, the investment should work as expected.
What is Bad Debt?
Having understood what constitutes good debt, let’s analyze bad debt. This is simply money that can’t increase your net worth, now or in the future. Bad debt is simply money lost and cannot be recovered. In accounting concepts, bad debt is written off as a loss since the money can never be recovered.
Illustration of bad debt
Suppose you buy a new game console and pay for it using your credit card, will you ever recover that money? The game will never generate income, and there is no chance whatsoever of selling it at a profit, thus the money is lost. This is a debt charged to your credit card that will never increase your net worth.
However, some bad debts are inevitable in life. For instance, taking a loan for a medical emergency constitutes inevitable bad debt. Though you will never recover the money, the money can save your life or that of a special someone on your life.Incurring a bad debt under such special conditions is not bad at all.
Learn to avoid incurring debts on things that you can live without. For instance, don’t take a loan to finance a wedding, an expensive vocation or buy a luxury car. Learn to save for such luxuries and buy them when you can afford.
However, pointed as out above, sometimes taking a debt is inevitable. Anytime you feel you can’t avoid bad debts, try using cash instead of a credit card. Credit cards attract a huge interest rate, sometimes as high as 24%. It is painful to repay a bad debt, but it is even worst when you have to pay it off with an huge interest rate debt. Thus, instead of using the credit card, apply for a personal loan which is more affordable. A personal loan attracts a lower interest rate, as low as 6%. This rate is not only affordable, but can also motivate you to pay. If you ever need a personal loan, visit Moneylenders in Singapore for more information.