Debt: Your friend or foe? You decide

NAV TL;DR

If you don’t have time to read through the whole article, you can check out our short version below:

Understanding debt:

Debt can be useful for many purposes, such as buying big-ticket items, convenience of payment, or meeting emergency needs.

However, if not properly managed, interest payments on debts can quickly snowball.

Before taking on any debt, ask yourself first if you can handle the repayments and reconsider if being in debt and paying interest is worth the item or service you wish to buy.

 

When you borrow money for any purpose, you are essentially in debt—you owe your lender—until you repay the full amount, often with interest.

Whatever name you call it: credit, loans, or borrowing, debt is an inevitable part of our financial lives today. Chances are, you have or know of someone who has taken on some form of debt—be it a credit card, study loan, or home loan.

Is that a good or bad thing? Truth is, debt can be a friend or foe.

When properly managed, debt can be a good friend and useful for various purposes such as to:

  • Buy things or services you cannot immediately afford to pay for in cash. These include a house, car, or higher education fees
  • Pay conveniently, such as using a credit card to purchase flight tickets or for online shopping
  • Meet emergency needs, such as to pay off a large, unexpected medical bill before insurance claims can be processed

With limited exceptions, money borrowed has to be repaid with interest. This is how debt, when not managed properly, can turn into foe.

Interest payment can be calculated in many forms, affecting how much you pay:

ONE-OFF REPAYMENT:
No interest is charged if you pay off your debt (e.g. credit card bills) on time and in full.

PER ANNUM (P.A.) AND EFFECTIVE INTEREST RATE (E.I.R) CHARGES:
The p.a. rate is the advertised rate that most loan providers publish. Note, however, that the advertised p.a. rate is lower than the Effective Interest Rate (EIR), which includes processing, administrative, and other fees.

Note: Calculations are for illustrative purposes only. Interest rates and amounts and fees may differ, depending on the loan type, structure, and provider.

Further, if the payment is not made in full, interest charges will kick in. These generally range between 26% p.a. and 28% p.a. The interest is calculated on a daily basis, which means the amount you owe is compounding with interest daily. Simply put, the longer you defer or roll over your outstanding debt, the more interest you will accumulate.

ORIGINAL PRINCIPAL REPAYMENT METHOD:
Interest is charged on your original principal (the amount borrowed), even though your principal declines as you gradually pay it off.

“REDUCING PRINCIPAL” REPAYMENT METHOD:
Interest is charged based on your loan’s remaining balance, which will gradually decline as you pay it off. Hence, the interest will also decline.

For example, if you took a bank loan with the following specifications, here’s how your loan repayment will look like:

Note: Calculations are for illustrative purposes only. Interest rates and amounts and fees may differ, depending on the loan type, structure, and provider.

In addition, there are also other fees and charges. In the case of credit cards, for example, these include:

  • Late payment fees (of about S$100, depending on your credit card issuer) if the minimum payment is not received by the due date.
  • Finance or interest charges on your outstanding balance, if payment is not received in full. These generally range from 26% p.a. to 28% p.a., depending on the credit card issuer.
  • Administrative fees, such as for foreign currency transactions.
  • Annual fees, unless these are waived. There are separate annual fees on principal and supplementary cards.

Defaulting on debt results in repercussions, which may sometimes be severe. In the case of secured debt such as a home loan or car loan, your house or car may be seized by the lender.

Being unable to repay unsecured debt can arguably have more dire consequences, as interest piles up through compounding. In extreme cases, bankruptcy proceedings may occur. In Singapore, bankruptcy is the legal status, declared by the High Court, of individuals unable to repay debts of more than S$15,000.

Financial health aside, bankruptcy may also impact your professional, emotional, and social health. It will hurt your credit rating, which may in turn impact life’s milestone events such as buying a home; it may also impact your employability for certain types of jobs.

CAN I HANDLE THE REPAYMENT AND INTEREST COSTS?

Remember that credit is money borrowed—with interest—from the future. Interest charges can compound and snowball quickly. For instance, banks charge a 26%-28% p.a. interest on credit card payments not made in full by the due date. This rate is calculated daily and is based on your outstanding balance and any new purchase charged to the card.

Generally, the shorter the loan period, the less interest you pay—but the higher your repayments.

CAN I DO WITHOUT THE THINGS I AM ABOUT TO BUY USING DEBT?

There are some purchases that may require some form of debt to finance. Be honest with yourself on what you would consider “necessary” versus “discretionary” spend. Is the item or service you wish to buy worth getting in debt and paying interest for? This will help guide your decision on whether to take on debt.

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