Debt has become quite the four-letter word after the economic crisis of 2009. According to CNBC, millennials fear debt more than they fear death itself. However, on closer inspection, you will realise that not all debt is created equal and sometimes having some debt is better than having no debt at all!
How do you determine whether a particular debt is good or bad?
Step 1 is to establish your goal. Are you looking for a place of residence for your family or a vehicle to commute or are you looking to make a profit or boost your career? If your purpose is a necessity and a loan allows you to achieve it, then it is a good debt. However, if you are looking at monetary gains, then move to step 2.
Step 2 is to determine if your returns will outweigh the loan amount in the short and long term. For this, you need to screen it through the parameters of Math, Research and Luck. Let us put this to work.
Taking a student loan: Ways to find out whether it bad or good debt
Say you are Sarah.
Sarah has a sales job that pays her S$50K a year. She aspires to get an MBA degree in Finance and begin a life of dealing with bulls and bears. She needs a loan of S$50K, which would require her to pay a monthly instalment of $803 per month for six years once she starts working.
- Do some research: Sarah looks up her recent alumni network from her choice of college on LinkedIn and discovers that most of them are working as research analysts in financial firms or junior associates in consulting firms. Average salary estimates for these roles are between S$80K to S$96K
- Crunch some numbers: Now for the loan (debt) to be a good debt, Sarah needs to make sure that in the short term, the returns (her new salary) covers at least the monthly repayment and in the long term helps her accelerate her career growth.
If she makes S$75K per year post her MBA, she would have an additional S$2K per month. If one were to assume 1K of that goes into an improved lifestyle and extra taxes, the balance S$1K is enough to pay her monthly instalment of S$803.
Here’s how it looks:
- Long-term value: Check
She projects that finance jobs have a higher rate of increment. She is likely to get to 100K salary in 4-5 years with her new job, versus taking 7-8 years in her current industry.
- Long-term returns: Check
- Factor in luck: “In fiction, we find the predictable boring. In real life, we find the unpredictable terrifying”. Sarah might graduate in the middle of an economic crisis or perhaps during an economic boom.
As with any decision, base your judgment on factors that you can control and foresee, along with a reasonably flexible attitude and appetite for risk.
Buying the latest gadget: Good or bad debt?
Now we’re talking about Keith.
Keith wants to buy a 4K HDR TV worth S$6000 to view high-quality movies with his family. He doesn’t have the money for this now, so he will be taking a monthly instalment of S$289 over 24 months.
Factors Keith should consider:
- Value of technology goes down with time. This TV may cost S$2000 in 2 years.
- CNN Money reported that the prices of LCD TVs are steadily declining year on year. So monetary gains are not a possibility here.
- New tech platforms are dependent on a well-equipped ecosystem. In this case, Keith may buy the high-resolution TV, but not all shows are produced in 4K. So Keith still ends up playing mostly HD quality content, which he could have watched on a less expensive TV.
Is this good debt or bad debt? If we consider this carefully and if we don’t have a lot of money to spare, this is probably not a good debt.
Investing in property? Here’s why it is good debt
Jason wants to invest in a two-bedroom condo near Balestier Road, for his 4-year-old son. A loan of S$1.2 million translates to monthly repayment of S$4000 for 30 years.
Here are the factors he considered before taking on debt:
- Balestier road, with its relative proximity to the city, its suburban location and schooling options, made it an attractive proposition for family renters. Jason was impressed by the steady growth in the historical rental rates in the area.
- The rent in the area would pay for the monthly instalment by itself, which would care of short-term returns. In the long run, the value of S$4000, (his current monthly instalment), could probably be worth S$3100K in ten years and S$2500 in 20 years, based on past inflation data.
However, his rentals from the property would continue to increase with the adjusted inflation. i.e., in the long run, this property would generate profits as illustrated with the sample graph below.
- Coming back to Jason’s original goal, in 20 years, his then 24-year old son would inherit a profit-making apartment, which he can choose to continue renting or start his own family in.
Clearly, not all debts are bad. In most cases, if you run them through the above model, you will have your answers and be in a position to decide whether you’re better off with the loan or without it.
If you’d like to read up more, these are the pros and cons of taking a loan in Singapore. Whether you take a loan or not, don’t fear – things have a way of working out in the end!
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