When ' GOOD' debts turn 'BAD' things get ugly

When 'good' debts turn 'bad', things get ugly
By Alok Kumar
Today's uncertain economic outlook calls for consumers to think about what they actually need to spend to maintain the lifestyle they are accustomed to, and to carefully assess if they have the financial flexibility to cope with any change in circumstances.
Although consumers may start thinking about spending on big ticket items like holidays, home improvement and car purchases to take advantage of the strength of the Singapore dollar before prices increase further or to enjoy current low interest rates, consumers should still exercise prudence in their spending.
A recent survey by GE Money Singapore revealed that 66 per cent of respondents felt that the uncertain economic climate has made them more cautious when considering a loan.
If a loan is required, one needs to evaluate the loan that one is taking.
Debt can be a complex issue and it is thus necessary for consumers to be able to differentiate between 'good' and 'bad' debt.
'Good' debt essentially helps one make purchases for items or essentials that one may not have enough savings for at the moment, but can well afford in the long run. It is essentially debt that can create value.
When used intelligently, debt can be positive and even be of assistance in building wealth. Examples of 'good' debt can broadly be divided into three areas.
These include loans taken to purchase assets such as property that may appreciate in value; for activities or items that are beneficial such as education to enhance one's qualifications that will likely increase one's earning ability and long-term returns; loans for business ventures for which business owners need cash that they do not have at the moment to fund or expand their facilities, with the aim of getting better returns in terms of business profits.
In addition, debt, if used prudently, can often be leveraged to one's advantage in certain circumstances. For example, one of the most common uses of loans applies to the purchase of cars.
We often see cars as depreciating assets but very often, it is a necessity or a mode of transport that gets one to work to earn a living.
While some consumers may be able to pay for their cars upfront or even pay for a property with existing cash without taking a loan, most will prefer to leverage debt so that they can free up cash for other purposes that may yield greater benefits in their opinion.
Depending on the individual's unique circumstances, the 'freed-up' cash can be used as emergency reserves to prepare for a rainy day.
Or, it may be used by savvy investors who can generate returns in excess of the interest rate they pay on their car loans. For example, there are also some small business owners who find it cheaper to take a car loan, and use the available cash to finance business needs, and hence gain better returns.
For instance, take a car loan quantum of $100,000 with a flat interest rate of 2.5 per cent (effective interest rate of about 4.61 per cent per annum).
A business owner who can afford to pay cash for the car might take full financing at these rates and use the cash to finance his business needs instead, considering that current business loans have an interest around 9 to 13 per cent per annum, effectively leveraging debt to his advantage.
A debt is considered 'bad' when a person has to stretch himself beyond his means, overspends and as a result, is unable to settle his loan repayments.
As a general rule of thumb, most financial experts recommend that an individual's total personal debt should not exceed 36 per cent of gross income.
Besides the debt-income ratio, keep in mind that a person can fall into a debt trap through the accumulation of late payment and interest charges as well.
For example, the concept of 'bad' debt often comes into play when discussing the purchase of discretionary items using high-interest credit cards and not having the ability to pay off the credit card bill in full.
The discretionary item, especially if purchased without considering one's financial situation, continues to lose value, while the amount one paid for it continues to increase.
Exacerbating the 'bad' debt factor, some consumers may be tempted into applying for in-store credit cards for the savings offers that range from 10 per cent to 20 per cent off the cost of purchases upon signing up immediately.
What people often do not realise is how much of that savings may be destroyed by the high interest rate, sometimes as high as 24 per cent per annum, on the card if they fail to pay for these items immediately.
Penalty charges for late credit card payment can also be incurred and amount to additional expenses on top of the higher interest rates.
Be careful to avoid turning 'good' debt into 'bad' debt by considering factors such as other existing monthly payment obligations, both fixed (eg housing, car, insurance) and variable (eg food, clothing) as well as possible shifts in the economic climate, to ensure that you are comfortable with the monthly repayments, and prevent unnecessary late payment charges.
Of course, even after careful planning, there may be instances when consumers need to make adjustments to their cash flow, or would require a loan.
Consumers appreciate and look for flexibility when considering a loan. In the GE Money consumer survey, 95 per cent of respondents stated that flexibility was an important or very important consideration when taking a loan.
Yet, more than half viewed their current personal loans as restrictive and felt imprisoned by the inflexibility presented by current industry offerings.
There are in fact, flexible personal loans in the market that cater to the consumers' needs for repayment flexibility. For example, personal loans that offer flexible repayment options including payment holidays and the option to pay interest only at the start of the loan, etc.
These payment features help individuals manage changing financial circumstances, by allowing customers to allocate cash to where it is needed most, without incurring heavy penalties for taking a break from the loan payment.
In fact, the GE Money survey showed that 43 per cent of consumers appreciated flexibility at the start of the loan, the time when they are usually strapped for cash, while 43 per cent felt that it was important to have flexibility to deal with unexpected events that can possibly take place midway through a loan's term.
Ultimately, a loan can help an individual, and can be a positive affair when taken responsibly. Consumers need to consider what is needed to leverage debt to their advantage and to prevent 'bad' debts.
Consumers need to build a good credit history that not only shows accountability and maturity about the individual, but will help the individual obtain other future loan facilities when needed.
Exercising financial responsibility and prudence when it comes to taking a loan will help individuals take steps towards building a better future for themselves and their families, and facilitate their future requirements at different stages of life.
The writer is chief marketing officer of GE Money, Singapore.
This article was first published in The Business Times on 4 July 2008.