Are all loans bad?

A backpacker emerges!
September 26, 2016

We have all heard of people getting into debt that spirals out of control and eventually leading them to bankruptcy and financial ruin. But are all loans and debt bad? Well, that really depends. The most important consideration when buying on credit or taking out a loan is whether the debt incurred is good debt or bad debt.

A man jumps over the word Debt on an arrow, showing that it's possible to overcome the problems of owing money to debtors and living with a large deficit

Good debt is an investment that will grow in value or generate long-term income. For example:

 

  • Taking out student loans to pay for a university education is an example of good debt. First of all, student loans typically have a low interest rate compared to many other types of debt. Secondly, getting a degree increases your value as an employee and raises your potential future income. Increasingly, for many jobs it is a must to have a degree especially in a highly competitive place like Singapore. However, student loans may not be always good debt- what if you are close to retiring? Would taking out loan for university education still give you the same benefits? Would you be able use the degree earned to get a job that pays higher and if so, for how long can you receive these additional benefits before you retire and pay off the student loan?

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  • In Singapore, with houses costing half a million dollars on average, we tend to have little choice but to take out a mortgage loan to buy a home. Due to the relatively low interest nature and that houses are generally seen as an appreciating asset in Singapore, mortgage loans are usually considered good debt as well. Even though mortgages are long-term loans (20-30 years on average), those relatively low monthly payments allow you to keep the rest of your money free for investments and emergencies (important to get a house that falls within your budget). The ideal situation would be that your home increases in market value over time, enough to cancel out the interest you’ve paid over that same period. Currently, we have a number of cooling measures imposed by the government to prevent a housing market bubble. This is good for new buyers. However, for sellers this may be bad news. Thus, if you are looking at property purely for investments, do your own due diligence and be up to date on market developments. Sure, mortgage rates are low at 1.5-2.5% but if you enter the property market at the wrong time like at the peak in late 2013, you would be down by 10% or so. Banks that gave you the loan could also issue a margin call if the value of your property falls significantly.

 

Bad debt is debt incurred to purchase things that quickly lose their value and do not generate long-term income. Generally bad debt also carries a high interest rate, like credit card debt. The general rule to avoid bad debt is: If you can’t afford it and you don’t need it, don’t buy it. A couple of examples:

 

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Car loans are another example of bad debt especially so in Singapore where car prices are ridiculously high! Cars are a fast depreciating asset in Singapore and can be considered as a luxury item unless you are a Uber or Grab driver or constantly moving around for business. If you are able to make money by utilising your car and overcome the 3% or more on car loans, should you consider getting a car loan. If not, this would be similar to buying luxury items that you don’t really need.

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