TODAY, I’d like to discuss the topic of debt.
There are generally two types of debt – good debt and bad debt. Good debt is generally considered an investment in some forms such as a mortgage, student loans or anything that will add value to your future. Bad debt is usually referring to debt that accumulates from the purchase of unnecessary or material things.
In the middle of this pandemic with people losing their jobs and finding it difficult to make ends meet, bad debt is becoming increasingly inevitable for many in the middle-income class group.
For many of us, when we hear these unfortunate, the common assumption is: “That will never happen to me”. Perhaps because you think you have a stable income or better money habits that you’ll never fall into the debt trap.
However, from my experience, getting into debt involves a series of gradual, innocent money mistakes, and at times, bad luck.
Nobody ever wants or plans to get into debt. Most of us are born into this world on a clean slate, without any debt. From there, we make a few bad money decisions, followed by undesired circumstances, and the next thing you realise, you’re in the debt trap and finding it difficult to get yourself back out.
One of the biggest mistakes that people make which leads them to debt is not knowing how much money they should commit to their lifestyle. You might think, but how can one end up spending more money than they have?
Let me illustrate an example to you.
Lisa is a fairly new graduate, and is living with her parents in their family home. Her corporate job earns her RM30,000 annually (RM2,500 per month). Since she’s living at home, her daily expenses such as rent and meals at home are covered by her parents, although she contributes RM600 to the household every month.
As her job requires her to be mobile, Lisa decides to purchase a secondhand car to make her life easier, with a budget of around RM15,000. However when she starts going car shopping, a car salesman convinces her to get a brand-new Myvi, which costs around RM45,000. He checks her monthly salary and her credit record, and informs Lisa that she can easily get a loan with her salary range. On top of that, the new car comes with free servicing and warranties, unlike a secondhand car.
Thinking she has no commitments under her belt, Lisa goes ahead and purchases the brand-new Myvi, and applies for a full loan option since she has not much savings as a new graduate. Her loan repayment is for nine years and comes to about RM570 per month, not including the RM450 she will have to fork out per month for petrol, car insurance and road tax.
On top of these expenses, Lisa also decides to upgrade her phone, as it is an essential in today’s corporate lifestyle. She takes a plan out with a telco company, which comes to RM250 per month for a phone and her line for a two-year commitment.
Let’s stop to look at the figures. Lisa’s take home salary is RM2,260 of which she is contributing RM600 to her household, and a further RM1,020 for her car expenses. After deducting her phone expenses, she is left with RM390 a month for her own needs such as clothing, dining, self-care and savings. Needless to say, this is nowhere near enough.
Lisa then proceeds to apply for a credit card and uses that to shop for her monthly needs. When the bill comes, she starts paying only the minimum amount, as she cannot afford to pay the full bill. What she doesn’t see is the monthly interest slowly accruing and compounding. Before she knows it, she’ll be thousands of ringgit in credit card debt, without the means of paying it off. This is how the debt problem begins.
Now, the main concern here is that Lisa has committed to purchases that she cannot back out from for the next nine years. On top of that, she has failed to build an emergency fund, normally about six months of expenses, to cushion against any unpredictable spending.
Considering the climate of the pandemic we are in, there is also a very real risk of Lisa losing her job and be left with a loss of income. When that happens, not only will Lisa not have any emergency funds to fall back on, she will have monthly bills to carry on paying off. She will likely be forced to charge those burgeoning expenses to her credit card.
The situation I’m sharing here isn’t something completely fictional. So many people like Lisa are not aware of how to prioritise their income early on in their working life. As a result, Lisa’s good intentions to get a solid start to her career would eventually lead her into bad debt.
But it’s not just the newly working adults who are falling into the debt traps. Newly married couples are also a common victim of making poor financial commitments, due to the excitement and expectations of settling down.
Many years back, my newly-wed friends Joshua and Cayden asked my advice on whether they were able to afford a RM800,000 home. Based on their finances at the time, that meant using up all their savings for a downpayment, and possibly being a little stretched on their monthly repayments. The bottom line, however, was they could afford it if they did not change the rest of their monthly household commitments.
I could see that they became excited at my response. Before they got ahead of themselves, I quickly reminded them that this is not taking into account the additional expenses should they have kids.
Many couples underestimate the cost of raising their children. When a newborn baby comes into their life, they then have to make radical changes to accommodate the additional expenditure of their changing lifestyle.
When a couple makes a high monetary commitment today, it may impact the financial health of their family in the future. In Joshua and Cayden’s situation, the best possible outcome could be a delay in achieving their financial freedom as a family. The worst possible outcome, however, would be that they lose their home. I advised them therefore to look for a cheaper property, one that would give them a bigger room to stomach any changes in their finances in the future.
In the excitement to get a home together, they decided against my advice and went ahead with the purchase. Six years later, and three children on, they unfortunately lost their home.
In this situation, while taking a home loan is generally considered a good type of debt, Joshua and Cayden’s decision to get an expensive home beyond their means eventually led them into bad debt.
The commonalities between the two cases I’ve highlighted here – Lisa, Joshua and Cayden – is that all of them did not start out thinking that they would ever get into debt. In retrospect, perhaps it was clear that they did not make the most future-proof decisions for themselves. But as they say, hindsight is 20-20.
In Lisa’s case, she thought she was helping her future self by committing to a reliable car and a decent phone she could work on. For Joshua and Cayden, they thought that committing to this house was a good move for their family in the future. In other words, all of their decisions started out as innocent oversights.
I am a firm believer that through stronger education of financial health, people like Lisa, Joshua and Cayden would understand the foundations of good financial practices and make wiser money decisions.
Debt traps are everywhere. There’s a tendency for people to commit to big purchases or costly financial decisions without knowing very clearly how these commitments would eventually impact them in the future. The key is to have the awareness to avoid them.
For a start, everyone should at least have a holistic financial planning done to see the impact of major purchases or life events such as a wedding, buy a house or the birth of a child, will have on their financial future. Ideally, a licensed financial planner should be consulted to provide proper guidance on the matter.
However, if DIY personal finance is preferred, there are free mobile apps available such as iWealth by Whitman, which could provide you with a snapshot of your roadmap to your financial freedom. By inserting your financial goals and commitments, the app would even show if your wealth is growing fast enough to fund them. In the event that it is not, you can start taking action by adjusting your expenses and lifestyle, or by consulting a licensed financial planner for the most holistic solutions.
Bad debt is sacrificing your future day needs for your present day desires ~ Suze Orman
Yap Ming Hui is a licensed financial planner. The views expressed here are the author’s. Any reliance you place on the information shared is therefore strictly at your own risk.