The Business Times, Saturday 05 July, 2003

Learn to tell the good debt from the bad debt

By GENEVIEVE CUA

DEBT seems so interwoven into the fabric of daily living that it is hard to imagine how one can cope without it. There is your home loan, car loan, credit card, various personal lines of credit, plus even your share margin account.

But there is good debt and bad debt. Obviously, if you're already deeply in hock to the bank, where your monthly pay is actually dwarfed by loan servicing, and you contemplate declaring yourself as a bankrupt, reading this isn't going to help.

How can you distinguish between good and bad debt, particularly at this time when advertisements are at pains to position various forms of debt as an advantage, and even as status symbols?

This is a question worth thinking through, as data released by the Department of Statistics on Singapore households' assets and liabilities are sobering.

The data showed that households' financial liabilities soared from 118 per cent of personal disposable income in 1995 to 174 per cent in 2000. The latter is substantially higher than those in major economies like the UK (116 per cent), Japan (100 per cent) and the US (90 per cent).

Joseph Chong, chief of New Independent, a financial advisory firm, says debt for consumption is generally unwise. But debt for investment can work. An obvious example is property, and the principle works as well for stocks. If you're considering an investment property, weigh the yield you expect to get from it against the financing cost. The yield is a function of the rental your property is expected to fetch against the purchase price.

At the moment, thanks to depressed property prices and low interest rates, you can get a positive differential between the yield and the financing cost.

Mr Chong reckons property in prime districts can give a net yield of 3 per cent. With low financing costs, the positive spread could be roughly one per cent, when it has been negative in the recent past.

The spanner in the use of debt for an investment property is deflation, which depresses the value of your equity in, say, a flat.

'As long as there is deflation, no one will invest because whatever you earn at a positive yield, you lose on the equity side.'

The equity portion of a property investment would refer to the portion financed out of your own cash. In a deflationary environment, while your equity value falls, your loan quantum remains the same. But Mr Chong believes deflation is no longer a danger, and he reckons central banks' efforts to reflate economies should lead to some price inflation for equities and real estate.

A good rule of thumb in the prudent use of debt would be to seek the lowest interest rates, and to use it for assets with a strong potential for returns.

Meanwhile, some things you should be wary of in terms of debt will be instruments charging you double-digit interest rates, for instance, as it will be tough to get a return on the funds to beat the cost.

What most people fail to note is that while the power of compounding works in simple things like deposit accounts, it is equally at work on the debt side.

In fact, on the debt side, compounding cuts deeply the higher the interest charge for your debt. Running up outstanding credit card balances at 24 per cent per annum, at a time when you earn a measly rate on your cash is a quick way to destroy wealth.

To get a handle on debt, you also have to understand how interest charges are calculated, and be alert to refinancing opportunities.

You can get a personal line of credit at relatively low rates today, for example, to which you can transfer your outstanding credit card balances.

Home loan rates also remain low, although you have to weigh any early termination penalties, if they apply.

While a home loan is an inevitability for most people, there is a simple principle to keep in mind if you are determined to start on the savings path.

Keep your outflow less than your inflow; or, rather, your expenses must be less than your earnings. It would also help to draw up a budget and keep track of your cash flow. It sounds like a boring exercise, but the discipline will stand you in good stead.