It must be tempting to splash out a bit now that the worst of the recession – and the belt-tightening that it forced on us – is over.

After all, some firms have started restoring pay cuts to employees and year-end bonuses have been paid.

With the mood improving, the urge to snap up that big-ticket item with cash or a loan is getting stronger.

Using cash is one thing, but excessive borrowing can lead to financial trouble.

‘Loans can help us to purchase high-value items or essentials that we do not have the savings or the full amount for at the moment – but it should be something we can afford in the long run,’ said GE Money Singapore’s president and chief executive, Mr Rahul Gupta.

And the same principle should apply, whether for a home loan, a car loan, a home renovation loan, one for education, or even one for a holiday.

‘Consumers need to ensure that loans taken are well within their means,’ said Mr Gupta.

Here are eight things to consider when taking out a loan:

1 A need or a want?

Before taking a loan, ask yourself if the item or service is meant to satisfy a need or a want.

Ms Tan Huey Min, assistant director at Credit Counselling Singapore, suggests that if it is a ‘want’ – not necessary and just for consumption – perhaps it would be better to save for it rather than to pay a ‘premium’ price (that is, the interest cost of borrowing). For instance, don’t borrow to pay for a vacation or a new kitchen appliance.

Take time to consider if there is an alternative to borrowing now or borrow a smaller amount instead. Better still, don’t buy it at all if it is unnecessary.

However, if the purchase is for investment purposes, then perhaps it is okay to get a loan. This could be for renovations that add value to your home, or enhancing your future income earning ability via training and education.

2 Interest cost of borrowing

Consumers should be aware of the type of interest rate that is stated in the loan agreement or marketing material.

And when considering loan options, compare like with like, said Mr Gupta.

Some loans use the annual percentage rate (APR), which reflects the actual interest cost of borrowing, while others refer to the simple interest rate. Shop around for the lowest APR.

The simple interest rate is calculated by applying a flat rate on the original principal amount for the entire loan tenure.

The APR is interest calculated based on the declining principal balance over the tenure of the loan.

As the borrower makes monthly repayments, the principal is reduced every month, so the interest payable on the principal also reduces each month.

Sometimes a loan comes with a zero per cent interest cost if it’s paid via a credit card. Make sure you pay off the debt before the interest starts to build up. If you miss a payment, you may be automatically bumped up to the highest annual interest rate of 24 per cent.

3 Current debt service ratio

Before taking the loan, calculate your debt service ratio. It is the percentage of your monthly income needed to service long-term liabilities.

It provides a useful guide to how much of your take-home pay – that is gross pay less 20 per cent employee CPF contribution and personal income taxes – is used to pay debts.

Debt payments are monthly expenses like mortgage, car loans, personal loans or even credit card debts. A healthy debt servicing ratio – debt divided by income – should be 35 per cent or less.

To put it another way, out of every $1,000 of after-tax and CPF income, you should spend $350 or less on debt repayments.

Ms Tan cautions that if the consumer already has a high amount of outstanding debt to service, it is best to pay down existing debt first before incurring more.

And even if your debt service ratio is less than 35 per cent, it is prudent to consider if you have surplus funds to take on another loan repayment after paying monthly living expenses.

Make sure you know your cash inflow and outflow before taking on another loan.

4 Loan tenure

It is worth considering the optimal loan tenure as it affects monthly repayments and interest paid.

Generally a longer loan tenure means smaller monthly repayments but a shorter loan tenure may lead to lower interest paid, says GE Money.

For example, Mr Mark Tan takes a $10,000 loan for a period of five years at an APR of 18per cent per annum (pa).

His monthly repayment is $254 so the total interest he will pay over the five-year loan tenure is $5,236, over and above the $10,000 loan amount.

If he takes a loan period of three years at an APR of 18 per cent pa, his monthly repayment will be $362 but the total interest paid over three years will be $3,015.

So to minimise the interest payable, a shorter loan tenure may be an option, but the repayments will be higher.

Some financial experts suggest you make the highest repayments you can manage so that you clear the debt in the shortest possible time.

When deciding on a loan tenure, consider your monthly commitments and take the appropriate loan tenure based on your monthly cash flow.

5 Early payment options

Not all loans allow customers to settle early, so read and understand the terms and conditions of the loan before signing up.

An early settlement fee is usually imposed if a loan is paid off early.

For example, if you redeem your GE Money personal loan before the full term expires, an early redemption fee of 3 per cent to 5 per cent of the outstanding amount at the time will apply.

Home loan customers are urged to look beyond interest rates and consider factors such as the lock-in period and penalty fees.

Another potential cost is the loan cancellation fee. An investor who buys a property on speculation and then applies for a loan might be hit with a cancellation fee if the property is sold before the loan is disbursed.

Cancellation fees can range between 0.75per cent and 1.5per cent of the loan amount, and can be quite substantial. For example, if the loan amount is $1million, the cancellation fee works out to $15,000.

6 Late payment fees

Most loans stipulate late payment fees. These are over and above the interest charged for late payment, so go through the terms and conditions of loan agreements thoroughly to ensure you understand them clearly.

Pay special attention to fees incurred for late payment.

For instance, credit cards typically charge a one-time administrative fee of $50 to $80 for late payment. This is besides the 24per cent interest charged on the sum that is rolled over.

So keep track of the payment dates and remember to pay before the due date. Try to have fewer loans or credit facilities and avoid having multiple sources of credit. In order not to incur interest and penalty fees, pay your outstanding credit in full.

7 Payment flexibility

Avoid defaulting on loan repayments as it will hurt your credit history. However, a typical loan tenure is for at least a year, and sometimes it is hard to predict what will happen so far into the future.

You might hit cash flow difficulties at some point, so it is worth looking for loans that offer some payment flexibility and provide rewards for prompt payment.

For example, Mr Gupta says that GE Money’s James personal loan, which caters to people earning $30,000 and above, offers several flexible payment options. They include allowing customers to defer two payments a year, paying only the interest component or paying higher or lower instalments at the start, or end of their loans.

Such features offer flexibility in managing your cash flow, particularly during unforeseen circumstances. GE Money customers are also rewarded for prompt payment by having part of their interest component, or their last instalment amount of the loan, waived.

For those who can’t meet their monthly payments, experts suggest that they approach their lender first for assistance to restructure a loan. Financial institutions will usually review such requests on a case by case basis. A responsible lender will work with its customers to provide a solution.

8 Other loan terms and conditions

Make sure you understand the key fees and charges stipulated by a loan agreement. This makes you aware of what to expect when a loan is taken and reduces any surprises after it has commenced.

If you are acting as a guarantor for a loan, be clear about the terms and conditions of the agreement, especially those related to your obligations as a guarantor.

Ms Tan says: ‘In the eyes of the creditor, the guarantor is the ’same’ as the borrower, meaning, both the borrower and the guarantor are jointly and severely liable for the loan.’

This means that even if you are willing to act as a guarantor, you should also consider your own ability to make repayments in case the principal borrower fails to repay.

She recalled a case in which a person (let’s call him John) became a guarantor for a stranger (Jim), who wanted to buy a car, in return for a fee.

When Jim defaulted on his car loan, the car financier pursued legal action against both people.

Jim could not repay and became a bankrupt. In the end, John assumed the balance of the loan, which was $30,000, after the car was sold and makes regular payment to avoid being made a bankrupt by the car financier.

Source: Sunday Times, 28 Feb 2010

Are some long-held principles on the markets merely myths?

THE depths of the financial crisis between 2008 and 2009 called into question a number of investment principles that have been accepted almost as truisms – until recently.

Are those principles simply fair weather crutches? That is, they work in a rising market but fail horribly in a bear market. Or worse, are they simply myths?

Here are some of them and what some analysts think.

Diversification

Not putting all of one’s eggs into a single asset is common sense. Portfolio construction typically works on the expectation that correlations among assets are stable based on historical trends. Assets are chosen for their low correlations with one another, so that not all should tank at the same time.

Between mid-2008 and the first quarter of 2009, however, the worst case scenario happened. The unravelling of the credit crisis triggered massive waves of selling and liquidity dried up. Correlations converged to one for almost all assets.

There were exceptions. US Treasuries proved to be the safest of safe havens, for instance. Gold also rallied, thanks to fears that the financial system was on the brink of collapse.

Diversification is still seen as a form of risk mitigation, and widely recommended by advisers. Perhaps the biggest lesson of the crisis, however, is that liquidity has been under-appreciated. Many portfolios were invested substantially in structured products that proved horribly illiquid, or worse, that actually unwound and caused heavy losses.

Says Christian Nolting, lead strategist (Asia-Pacific) for Deutsche Bank Private Wealth Management: ‘We see value in the asset allocation approach and have implemented the same in our private client portfolios. An appropriate distribution of wealth among different asset classes, with an individual strategy geared to the risk-return profile of the client – complemented periodically by dynamic and tactical decisions – is key for a sustainable and satisfying portfolio return.’

‘Time’ diversification

This principle says that the longer your horizon, the more equity risk you can take. In particular, it is common that presentations by banks and fund houses show long-term returns of an index, usually the S&P500, to justify this thinking.

Boston University professor Zvi Bodie believes that the fallacy of time diversification is perpetuated as part of the fund management industry drive to sell funds.

As he told an audience at the National University of Singapore recently, if stocks became safer in the long run, they would not carry a risk premium. An indication of how risky stocks are can be gleaned from the cost of protection, which rises as the time horizon lengthens. Conventional advice, he says, based on the mistaken principle of time diversification, leads to portfolios that are riskier than most consumers realise.

Buy and hold

This mode of investing in markets may truly be one of the biggest casualties of the bear market.

Almost all strategists now say that shifts in tactical asset allocation – that is, shifts around a long-term strategic mix of assets – have become more frequent since the crisis began. They expect 2010 to be no different, as uncertainties remain on the economic outlook and the manner and timing in which central banks will begin to withdraw the massive stimulus.

Financial advisers such as Providend and New Independent have launched portfolio services that actively allocate to exchange traded funds.

Such portfolio services are typically aimed at generating a positive absolute return. The rub, however, is that retail investors with modest sums may not have access to such advice, where the minimum capital for a portfolio can start from $100,000.

An absolute return objective is also not a panacea as a lot will depend on the fund manager or adviser’s skill and ability to time markets.

Schroders’ Asia-Pacific head of multi-assets, Al Clarke, says buy-and-hold is still a sensible strategy ‘as asset allocation is a difficult endeavour that requires time, technical understanding and discipline’.

‘An investor should construct an appropriate asset mix that will deliver the return and risk objectives they need for that investment . . . At Schroders, we believe we can add value through making sensible changes to the asset allocation based on value, cycle and liquidity.

‘What may not make sense is suggesting the best asset allocation to meet the investor’s objectives is 100 per cent equity and leaving this as ‘buy and hold’. This will lead to volatile outcomes and as history has demonstrated, can deliver sub-standard returns for prolonged periods of time.’

Balanced and target date retirement funds

These are marketed as core holdings in a retirement fund that investors can effectively buy and hold. While balanced funds are a staple in the CPF menu, there are not many target date funds here. The latter refer to those designed with a maturity that should coincide with your retirement. Assets are automatically rebalanced such that as the fund nears maturity, it should be invested in more conservative instruments.

In the US, target date funds, in particular, are under tough scrutiny as the market plunge in 2008 caused severe losses among funds that are near maturity. Bloomberg has reported that target date funds labelled 2000-2010 lost an average of 23 per cent last year, with some dropping as much as 41 per cent. The average 2050 fund declined 39 per cent in 2008, while the S&P500 fell 38 per cent.

Prof Bodie heaps particular scorn on target date funds as ’silly, counter productive and disingenuous’. Such funds, he says, do little to provide investors with a secure income in retirement.

The upshot of this is that retirement planning should start with a projection of one’s desired income in retirement, and then choosing assets that are likely to deliver and protect that income stream. This is how institutions with a stream of future liabilities invest. This approach would favour direct investments in bonds, in particular inflation indexed bonds. There are no inflation-linked bonds here. Many investors also sniff at Singapore government bonds whose yields are low. Corporate bonds are also not as easily accessible to retail investors, as they require minimum investments of at least $200,000.

Source: Business Times, 19 Dec 2009