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Loans: The good, the bad & the ugly

AT some point in our life, many of us will face the prospect of taking out a huge loan, either to pay for our first car or to buy a home. Easy access to credit can be both a boon and a bane. Debt can be good if used prudently and responsibly. If not, it would be too easy to fall into the debt trap which can be difficult to escape.

"The important thing is that we should only take on debt that is manageable," says Mohamed Akwal Sultan, chief executive officer of Agensi Kaunseling dan Perkhidmatan Kredit.

AKPK is a credit counselling and debt management agency set up by Bank Negara to promote financial prudence among Malaysians. It also provides free services to assist individuals in resolving their debt problems with financial institutions.

What would be a manageable level of debt for an individual? One way to assess this is by looking at how much the monthly loan repayments would cost, and how big a bite it would have on your paycheck.

Mohamed Akwal estimates that loan repayments should not account for more than 40 per cent of your monthly gross income. After also deducting for tax and EPF, this would leave you with about 25 to 30 per cent of your gross income which should comfortably cover your normal monthly household expenses.

What about credit card payments?

If you use your credit cards to pay for your household expenses and settle the bill in full every month, it should not count as a loan repayment. However, if you had used your card to buy something expensive with the intention of paying it off over several months, it should be counted as a loan repayment.

"Because of the high interest rates, try to pay off your credit card balance in full every time. If you have to carry a balance, you should settle it within three months," says Mohamed Akwal.

He adds that although credit cards offer a convenience to users especially as a replacement for cash, it can be easily abused. He would know as the agency is currently handling debt cases amounting to just over RM500 million in total, half of which involve unpaid credit card bills.

More important, avoid the pitfall of using short term financing, such as credit cards and overdraft facility which charge higher interest, to pay for debt that would take more than six months to settle.

"Make sure you match the funding," says Mohamed Akwal.

The reason being that every loan product has been designed for a specific purpose. The basic idea is that the riskier the loan, the higher the interest rate. And short term loans cost more in interest than those with a longer tenure.

A loan that is backed by an asset as security, such as a car or a house, is less risky for the bank which can resort to selling the asset to recover any outstanding amount in the event of a default by the borrower. That is why unsecured loans, which are not backed by assets, carry higher interest rates, as in the case of personal loans or credit cards. For example, interest on a housing loan currently can be as low as 6.5 per cent a year, compared to credit cards' typical annual rate of 18 per cent.

Long term loans, such as for buying a house, however could expose the borrower to fluctuations in the interest rates. This is because most home loans charge a variable rate of interest, which moves along with changes in the bank's base lending rate. If you are shopping for a home loan and think that interest rates would be trending higher in the long term, then you may be better off with a fixed interest rate loan, Mohamed Akwal says.

As to medium term loans, what is commonly offered by banks is hire purchase financing. Most car loans use this form of financing, which differs from conventional loans in the way interest is charged. Instead of calculating interest on the remaining balance after deducting repayments every month, hire purchase loans charge a flat interest rate on the principal amount for the duration of the loan. So, a hire purchase loan that charges five per cent interest for five years would mean that you will be paying total interest amounting to 25 per cent of the principal amount. If the loan is for ten years, you will be paying 50 per cent interest on the principal amount. To illustrate, if you had borrowed RM50,000 under hire purchase at five per cent interest, your payments for the loan would total RM62,500 over five years, and RM75,000 over ten years - a RM12,500 difference!

In effect, what this simply means is that a five per cent per annum interest on a five-year hire purchase financing is comparable to 9.15 per cent in annual interest for a conventional loan.

Sometimes you may want to consider having an extended duration or tenure for your loan to enjoy lower monthly repayments, to make it more affordable. But be mindful that you would end up paying more interest in such a situation. As such, when negotiating with the bank, ask how much the total cost of the loan would be, including fees and charges. You need to be aware of what you are taking on so that there are no surprises later. What you don't want to happen is ending up still owing the bank if you decide to sell the asset half-way through the loan period, because the proceeds from the sale is inadequate to settle the outstanding loan in full.


Based on wants, not needs

Easy access to credit is a convenience that you should use prudently. Don't confuse what you want for something you need.

Not checking if you can afford the monthly payments

Have an idea of what your monthly expenses are. If there isn't much money left over to pay for another loan, then you may need to reassess your priorities.

Not knowing the total cost of borrowing

Always take into consideration the additional fees and charges that would add up to the cost of your loan.

Not matching the funding with the asset

Would you use your credit card to pay for the down-payment on a house? An AKPK study reveals that if you only pay the minimum balance on your credit card, it would take you seven years to settle the debt - assuming you don't use it for new purchases during that time.

Not making timely repayments

Most banks charge interest and penalties for late payments, which have a compounding effect that can add up quickly if they remain outstanding.

Withdrawing cash from one credit card to make the monthly payments on another can also rack up interest charges quickly. This is because interest charges on cash advances begin from the moment you take the money out. There is also an additional fee charged for each cash withdrawal, ranging from three to five per cent of the total money advanced.
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