Blog #12 Credit and Debit

The assets side of a personal balance sheet is understandably more glamorous than the liabilities side. But managing your debt well is important if you want to increase your net worth.

If you’re like most people, you will have a collection of liabilities such as an education loan, a car loan, a long-term mortgage, a renovation loan and a few credit cards.

Debt can be good or bad, depending on the purpose for borrowing and the loan quantum. In this blog, I will offer some advice on how you can manage your debt instead of letting it control you. I promise to be brief.  Details will be covered in subsequent blogs.

1. Practise mongamy – own one credit card

These days, almost any credit card is loaded with perks like discounts, rebates, one-for-ones and air miles. Having more credit cards may be counter productive as it may lead you to overspend (and believe me, research shows it).


2. Monitor credit card spend with a cash budget

The average credit card holder in Singapore has 6 credit cards, so I’m not confident that many people will heed my first advice. But as I said, having more cards can increase the spending adrenalin particularly if you use them to max out on “good deals” or card promotions.

Don’t just take my word for it.  Psychology research shows that while most people are not necessarily addicted to owning things, we are excited by the “thrill of the hunt”. These studies use brain imaging technology to peep into the brain’s activity when subjects are shown stimuli with varying degrees of pleasure and thrill intensity. They reveal that it is the anticipation of an exciting or pleasurable experience rather than the actual experience that leads to a surge in dopamine, the “pleasure chemical” in our brains. Read here for more. More credit cards may increase the frequency dopamine surges that could ruin your personal finance.

But it isn’t all doom. If you choose to be part of the “many credit cards tribe”, but seriously want to keep your spending under control, I suggest you spend with the help of a cash budget.

Recall from the previous blog that a cash budget is a monthly projection of your income and expenses for the coming year. The purpose of cash budgeting is to instill discipline in spending. For example, suppose your expense budget for the whole April is $2,000, and by the 20 April, you’ve already chalked up spending of $1,800. This raises a yellow flag. It signals that from now till the end of the month, you have to watch your spending like a hawk.

For the cash budget to work well, you need to track all your expenses in real time using whatever method is convenient (e.g. a budgeting app or the notepad on your cell phone). The method is less important than having a good record keeping system and the discipline to stick to your budget.

 

3. Pay credit card bill on time 

Credit cards have a peculiar feature. You don’t have to make the full payment for last month’s bill by the due date. You can choose to make the minimum payment (usually 3% of the bill or $50 whichever is larger). If you choose the minimum payment option on a $10,000 bill, you need to pay just $50 to the bank this month and roll over the balance to the next month. When next month comes, you can roll for another month by making the $50 minimum payment and so on.

According to a 2014 report by Credit Bureau Singapore (CBS), 1 in 5 credit card holders are habitual revolvers (people who failed to pay their credit card balances in full for at least 3 consecutive months). As there were 8 million main card holders in 2014, based on average of 6 credit cards per person, an estimated 267,000 card holders were habitual revolvers! Gambling and overspending are the main reasons for this high roll over rate.

Rollover aren’t free. In fact, banks charge interest rates of at least 25% p.a. on rollover balances. Moreover, interest is compounded monthly on any unpaid balances. This means that clearing even a modest rollover balance (e.g. $10,000) can seem to take forever. And $10,000 is small change compared to the amounts some people roll over using multiple credit cards (read more here).

Responsible credit card do not do rollovers because (a) they are disciplined spenders and (b) they understand the painful consequences of not paying their dues in full. Do you? Have a go at the following quiz.

Imagine you rolled over a credit card bill of $10,000. The bank requires a minimum payment of $50 a month. The interest on unpaid balance is 25% p.a. How long will it take to clear your debt if you repay $50 each month? What is the total interest on your roll over debt? What if you repay $500 instead of $50 each month?

The answers will shock you – click here.

 

4. Downsize your mortgage loan

Housing loans are also known as mortgage loans. You can get a mortgage loan for a maximum loan period (tenor) of 30 years (or up to age 65). The bank will calculate a monthly repayment amount based on your loan size, loan tenor and the prevailing interest rate. The bigger the loan, the longer the loan tenor and the higher the interest rate, the more dollars are sucked from you to feed the loan (to the bank’s delight of course!).

You can’t do much about property prices, but you can do a lot to lower your mortgage interest cost by borrowing less and by making regular principal repayments after the loan “lock-in” period.

To illustrate, if you borrow $1 million for 30 years at 3% interest rate, your monthly loan installment works out to be $4,216. Multiplying this by 360 months means that by the time you reach the end of the loan period, you would have paid a total sum of $1,877,760 to the bank. Rub your eyes and stare at this figure again. Recall that your principal sum is “only” $1 million. Subtracting this from $1,877,760 means your interest cost is a $877,760. Million dollar mortgages are not uncommon today, but I bet you that very few borrowers are aware of the staggering sums they pay as interest over course of a long loan tenor. By borrowing $800,000 instead of $1 million, you can cut your interest by half. Furthermore, if you reduce your principal by $25,000 every 5 years, you shorten the loan repayment period to about 26 years, and you cut your total interest cost to $351,763.

 

5. Avoid personal loans

They’re called by different names, easy to apply (the minimum annual income is S$20,000), require no collateral, and promise “fast approvals”. I am talking about personal loans.

Like credit cards, personal loans are a form of unsecured credit. Unlike credit cards which are for point-of-sale expenses, personal loans are general purpose loans. This means the borrower can choose how he wants to use it. For example, he can use the loan to invest, buy a computer, or go on a luxury cruise. The flexibility of personal loans make them very enticing.

But attractive loans like these come with a high price. In fact, personal loans are the most expensive type of credit after money lender loans and credit card rollovers. To give you some idea of the cost of personal loans, I trawled Moneysmart’s website for “best personal loans”. Five names came up: Citibank, DBS, POSB, Standard Chartered, and HSBC. The eligibility criteria for personal loans from these banks are pretty similar. But the interest rates vary widely. Below, I will focus on two personal loans, one by Citibank and the other by POSB.

Citibank’s personal loan is called Citi Personal Loan. This is an installment loan where the borrower makes a monthly repayment consisting of part principal and part interest. The shortest loan tenor is 12 months and the longest is 60 months. Using the online loan calculator, I asked for the monthly installment for a principal sum of $10,000 for 12 months. The calculator returned $874.51.

Citibank’s website displays two interest rates for this loan: a nominal interest rate of 4.94% p.a., and an effective interest rate (EIR) of 9%. Confused? You are not alone. Long story short, both interest rates are correct in that they produce the same monthly installment of $874.51 but using different formulas. For borrowers, the bottom line is this: the EIR and not the nominal rate is the true cost of the loan. The next blog will provide a fuller explanation.

Let me now turn to the POSB Personal Loan. This loan has a tenor of 12 months to 60 months. The minimum yearly income to obtain this loan is $20,000. For customers with a minimum income of $30,000 and above, lower interest rates apply. POSB charges a processing fee of 3% on the principal. So, for a $10,000 loan, you receive only $9,700 after the processing fee.

Similar to Citibank, POSB’s website displays both the nominal and effective interest rates. For higher income borrowers, the nominal interest rate for a 12-month loan of $10,000 is 7.99%, while the EIR is about 20% and the monthly installment is $900.

Whether you look at the monthly installment or the EIR, you can see that the POSB loan is more expensive than the Citibank loan.

I can go on with other examples, but the general point I want to make is this:

Given high interest rates and other charges, there are very few situations that can justify borrowing a personal loan.

In the next blog, I will explain the above loan calculations in detail.

 

Further Reading:

“What you should know about about credit cards (MoneySENSE) .

Sections (* = must read)
– What is a credit card?
– When can you use it?
– Understanding the monthly statement
– Understanding terms and conditions (*)
– Understanding the fees and charges (*)
– Using your credit card wisely (*)
– Non-repayment and overdue repayment (*)
– Guarding against fraud (*)
– Questions to ask before you sign up for a credit card

Using credit cards when overseas (some useful facts here)

Are You a Compulsive Buyer?

A compulsive buyer or “shopaholic” in popular jargon is someone who is chronically addicted to buying – to the point of incurring heavy credit card debts. Like Becky Bloomwood, the protagonist in the hilarious movie, Confessions of a Shopaholic (watch the trailer).

To find out if you are Becky Bloomwood (or a male version of it), take this test

The test is a short questionnaire developed by social scientists, Ronald Faber and Thomas O’Guinn in their seminal 1992 paper, “A Clinical Screener for Compulsive Buying”, Journal of Consumer Research, 19, 459-469. Read the paper here (technical).

Here’s are some proven tips on how to keep control compulsive buying in check:

  • As already mentioned, always cash budget your expenses and track them religiously.
  • Never buy without a shopping list.
  • When shopping online, head straight to the item. A fatal mistake is to go from link-to-link on the website because your eyes are bigger than your wallet.
  • Never shop when you’re stressed out – you can’t think straight.

 

 

 

 

 

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