Angeline C (iCompareLoan.com)

Quick question: Should you borrow even if you have sufficient cash?

Some of you may think of this as a one answer question but really it all depends.

The main criteria is whether your funds are able to generate a return higher than the cost of funds

Example: You have S$100,000 in your CPF Ordinary Account, earning 2.5% p.a. You can use the funds to pay for your purchase of a home or you can apply for a loan at a starting interest rate of 1.9%. Some may think they should use up all their CPF to pay for the house as they do not want to be burdened with a large loan and pay interest to the bank. But if you take a step back, wouldn’t it make sense to pay the bank 1.9% and earn 2.5% from your CPF account. In that way, you still earn 0.6% p.a. If you use up all your funds, it means that you can no longer generate any interest on the S$100,000.

Another aspect of debt that could help some investors is through the multiplication effect of leverage.

If you only have S$300,000, debt can help you to purchase a condo worth S$1 million. If the property market was booming, it is possible that you could turn the unit around in the market, selling the unit for a higher price and possibly make a 20% return on the S$1 miilion or S$200,000. This translates to a higher return of over 60% on your original capital of S$300,000.

In the case of corporations, they may maintain facilities with banks even if they have funds. This is to maintain relationships with the bank so that when they come across an attractive acquisition target for example, they know they can afford it and make quick decisions to capitalize on the opportunity.

But of course not all debt is good.

Example: Mr Tan buys a condo for S$1million, with a housing loan of S$600,000 with the intention to rent out the unit. In his mind, the unit can be leased for S$4,000 a month, which will cover his monthly loan installment of S$3,500. Thus it is a positive move.

But is it really?

The ability to rent out the unit at $4,000 would depend on the market condition and a bit of luck.

Do not simply plunge into any investment decision without doing your homework.

Think of the worst case scenario. In this case, it is possible, that Mr Tan is unable to find a tenant for more than 6 months. In this case, he will have to service the loan in addition to the maintenance charges of the condo. Does he have the cash to do so even in this scenario? If Mr Tan can’t service the loan, can he sell the condo at a higher price?

Another example of bad debt is to take up a loan to finance a consumer good. For example, a car, luxury items which depreciate in value. Interest on personal loans are typically higher than for housing loans. The highest interest rates are usually imposed on credit card debt.

This sort of debt eats up your funds over time and you should strive to pay off the debt as soon as possible.