Understanding and properly managing debt is the key to using it without danger. Here are six questions to ask yourself when you’re thinking of taking on additional debt.
Remember that saying about how fire is a good servant but a bad master? Yeah, it’s the same with debt.
There is nothing inherently wrong with debt – in fact, our entire modern-day financial system is driven by it. However, as with many things, being reckless with debt, or not taking the time to fully understand what you’re doing, can get you into some pretty sticky situations.
In the spirit of helping you make better financial decisions, here are 6 questions you should ask yourself before taking on debt – whether new or additional.
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Question 1: Is this good debt or bad debt?
Debt may be categorised into “good debt” (productive debt) and “bad debt” (non-productive debt).
Non-productive debt is debt that doesn’t give you a positive financial return. The vast majority of consumer debt falls into this category, for instance, taking a loan to pay for a holiday or maxing out your credit card on Michelin-starred restaurants.
On the other hand, productive debt is debt that furnishes a return by enabling you to make more money, directly or indirectly. One example would be an education loan to earn a professional qualification that would give you better prospects in your career and enable you to earn a larger paycheck. Another would be taking a home mortgage to pay for a property that provides a high rental yield or can be flipped for a profit.
Of course, it’s not always so clear-cut; buying a car is almost always loss-making, but the convenience and time savings it offers may outweigh the financial cost for some. Also, if you’re getting a car to earn money as a Private Hire Driver, then the car mortgage becomes a productive debt.
Nonetheless, when a debt is evaluated to be a bad or non-productive debt, think twice before taking it on.
Question 2: What is the opportunity cost of taking on this debt?
If you’re ambivalent about whether the debt is productive or non-productive, asking yourself what is the opportunity cost of the debt may give you better clarity.
Every dollar that goes into debt is a dollar less for saving or investing, which means there’s always an opportunity cost when borrowing. Even worse, the opportunity cost rises when you factor in the effect of compounding interest.
Here’s another way to frame this question: Are you on track with your savings and investment goals? If not, you should not proceed.
Question 3: How will you pay this debt back, and by when?
Taking on debt is easy; all it takes is a couple of taps on your smartphone these days. Paying debt off? Not so easy.
Hence, an important (but often neglected) dimension of borrowing is properly managing your debt repayment, but successfully doing so will depend on the type of debt, as well as personal preferences.
Take, for instance, personal loans. They offer fixed monthly repayments and tenures, so all you have to do is to make sure you make a payment every month.
However, this means that your cash flow is also locked up until you pay off your entire loan, and you'll have to pay an extra fee if you want to pay your loan back early.
On the other hand, credit cards offer more flexibility, as you need only pay for the amount you use. Some people are great at managing their credit card use and never carry a balance.
They may even throw in a balance transfer or two, making daring last-minute escapes from imminent interest charges (not financial advice, btw).
Recognise that taking on debt means incurring a financial responsibility, one that needs a sound plan to manage properly. Therefore, before taking on additional debt, stop and ask yourself what’s the plan for paying it off.
Read more:
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Question 4: Are there better interest rates?
There are many different forms of debt that cater to different needs, but generally, the lower the interest rate, the better. Low-interest debt is not only easier to pay off than high-interest ones, but a lower interest also means less indebtedness.
Understand that the interest on your debt (together with any fees or charges) represents the cost of borrowing, which can be higher than appears at first glance. For a more accurate representation of the cost of borrowing, look up the Effective Interest Rate (EIR).
Searching for lower interest rates is a matter of matching the debt to the purpose. Personal loans are often touted for general use, but purpose-built loans, such as renovation loans, could have a lower EIR (although such loans cannot be used to pay for expenses not related to your renovation), which means your overall debt is smaller.
Question 5: Can you use cash instead?
This question is often intertwined with another, equally pertinent important question: Can it wait?
Assuming that it is not an emergency (i.e., yes, it can wait), it is generally better to pay in cash instead of taking on debt; the added costs of interest charges and lender’s fees mean you’re paying a higher price overall.
If you do not have sufficient cash on hand, you’ll have to save up the amount you need – which could take time. This, admittedly, can be difficult, more so for some than for others.
Still, asking yourself this question is a good way to stave off taking unnecessary debt. It can also highlight an inability to delay gratification, leading to opportunities to examine the root causes of this behaviour.
Question 6: How will this debt affect your mortgage limit?
If you’re planning to apply for a mortgage in the near future, you should consider carefully whether to take on any more additional debt.
This is because of the debt-control measures put in place by the authorities, specifically the Total Debt Servicing Ratio (TDSR) and the Mortgage Servicing Ratio (MSR).
When applying for a mortgage, your monthly mortgage payments cannot exceed 30% of your gross monthly income. This is the MSR cap.
Additionally, the total monthly repayments across all debts (including the mortgage you’re applying for) cannot exceed 55% of your gross monthly income. This is the TDSR cap.
This is how the TDSR and MSR affect you. If your existing loan repayments already make up, say, 40% of your gross monthly income, your “quota” for mortgage repayments is only 15% of your gross income.
This means that you may not be able to get a home mortgage that is large enough for the property you want, not until you pay off your existing debt, at least. As a result, you may have to delay important life plans such as starting your own family.
Hence, before adding more debt, be sure to check how it would impact your mortgage limit.
Read these next:
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