Are Your Debts Good or Bad?

Debt is like a double-edged sword. It can help you, but it can harm you too. Making good use of debt can create wealth for you, but mishandle it and you can possibly be put into bankruptcy.

Therefore, we should learn how to use debt wisely to let our money grow. Debts can be classified as bad debts and good debts. Here’s a table showing annual interest rates of various types of loans currently:

CURRENT INTEREST RATES FOR VARIOUS LOANS
Type of Loan Interest Rate
Mortgage 1.8% – 3.75%
Education 4.6%
Car 5%
Renovation 5% – 7%
Personal Unsecured 14%
SME Unsecured 5% – 10%
Credit Card 24%

Bad Debt

bad debt

What types of debt should be considered bad? Any expense-related debts can be classified as bad. Examples include taking a loan for travel and taking up a hire purchase with interest for your home furniture.

This is because the value of these purchased goods usually drop after you purchase them. For example, after getting a new TV at $3,000 hire purchase, the value of it drops by $500 in the following month.

Another popular form of debt comes from something almost all of us use – credit cards. If used smartly, credit cards can help us enjoy discounts and savings when we make purchases from relevant merchants. On top of that, it allows us to carry less cash in our wallets and makes payment convenient. However, if you were to delay your credit card debt repayments, the interest payment can be as high as 24%. Let’s say a person has just charged $10,000 to his/her credit card today and defaults on his/her repayments for the next 3 years. Based on the rule of 72, the total debt would have grown twice the size 3 years later. Yes, that’s a whopping $20,000!

Therefore, please think twice before you use your credit cards or when taking up bad debts. You may land yourself in huge financial trouble if you fail to make repayments on time.

Good Debt

mortgage

A loan that helps you to acquire an asset which can potentially earn a higher rate of return than the loan interest rate can be classified as a good debt.

Mortgage and business loans are examples of good debt. In fact, the interest rate on mortgage is the lowest among different types of loans which we can get. Although a HDB Housing Loan is at 2.6% per annum currently, you can potentially earn a higher yield if your house is timely sold in the future. At the same time, CPF Board credits a return of 2.5% per annum into our CPF Ordinary Account (CPFOA). This means that your HDB Housing Loan interest is offset to 0.1% annually.

Many successful entrepreneurs have also benefited from the use of good debt. Through the use of business loans, small enterprises are able to expand their businesses. Large companies are able to grow even bigger.

Another example of good debt is your education loan. The knowledge gained through your education allows you to acquire a good job and earn living. It is definitely a worthwhile investment.

In summary, leveraging on good debts to grow your wealth is one of the important principles to growing rich.

Be careful not to over-borrow

Here’s a warning – do not over-borrow, as you may get yourself into trouble. How do we ensure then, that we do not over-borrow?

Your monthly debt repayments should not add up to more than 35% of your monthly salary. If your monthly salary is $4,000, then your monthly debt commitment should not exceed $1,400.

Avoid bad debts and use good debts smartly – this is a sure way to create great wealth for yourself.

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Compound Interest & the Rule of 72

“Compound interest is the Eighth Wonder of the World. He who understands it, earns it … he who doesn’t … pays it.”

– Albert Einstein

 

Compound interest is paid on the initial principal and also any interest that is accumulated for previous periods of a deposit or loan. When Albert Einstein discovered the rule of 72 which applies to compound interest, he was instantly awed at the wonder of it. He believed that anybody can make use of compound interest to grow their wealth. So, what is the rule of 72?

To put it simply, the rule of 72 helps us to calculate the required time to double our wealth. The formula below explains:

72 / Rate of Investment Return = No. of Years to DOUBLE your Money

If you have $20,000 and this amount of money reaps you an investment return of 3%, you will required 24 years for it to grow to $40,000, twice the size of your initial investment. So, if you can achieve a higher rate of return of say 7%, you will only require 10 years for the same $20,000 to double.

The difference between an investment that yields 3% and an investment that yields 6% may seem small in a one-year period. But compound this for 40 years and the difference will be immense. The table below illustrates this (assuming an initial capital of $20,000):

Number of Years

3% Investment Yield

6% Investment Yield

5

$23,200

$26,800

10

$26,900

$35,800

20

$36,100

$64,100

30

$48,500

$114,900

40

$65,200

$205,700

 

Therefore, if you wish to achieve financial freedom and retire as early as possible, it is crucial to understand how compound interest works to help you grow your money. By keeping your money invested, your returns compound. The longer you stay invested, the greater the compound effect.