Benjamin Franklin once famously said, “Rather go to bed supperless, than rise in debt”.
Even though the modern consumer economy runs on debt (credit), for the individual, being in debt still carries negative connotations. But not all debt is created equal. In fact, there is what is known as good debt and bad debt.
In this article, we will explain the differences between the two and why you shouldn’t worry too much about mortgage debt (plus some tips on ensuring you never have to).
What is Good Debt and Bad Debt?
As a rule of thumb, you can tell good and bad debt apart with one simple question – does this debt have the potential to pay me back more than what I put in? In other words, can this debt add to my future net worth? If the answer is yes, then it is likely good debt. If it’s no, then it’s likely bad debt.
Here’s an easy example of bad debt – personal loans taken out to finance luxury consumption. Putting yourself in debt to go on a fancy vacation or buy an expensive car, for example, has zero potential to pay you back more than you put in.
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Are Home Loans Good or Bad Debt?
When viewed from this perspective, home loans are almost always good debt. For one, over the long term, property typically appreciates. For example, the Private Residential Property Price Index has increased by 17 times since 1975. This means that on average, a $100,000 private property back then would be worth $1.7 million today.
The same goes for HDBs. From 1990 till now, the HDB Resale Price Index has increased by 5.7 times. And even in the face of a global pandemic, property prices have remained stable, with the PropertyGuru Singapore Property Market Index actually increasing for three consecutive quarters since Q2 2020.
In short, home loans can be, in most cases, classified as good debt because their value will most likely increase over time. This will add to amount of equity in your home – defined as the current market value minus the outstanding home loan balance. And since your net worth is calculated by taking your assets minus debt (aka equity), any increase in your home equity also increases your net worth.
The important caveat here is “in most cases”. Like any situation, there are grey areas.
Blurred Lines – Can Home Loans Ever Become Bad Debt?
Before we return to the topic of home loans, let’s use a different example to illustrate how the boundaries between good and bad debt can get blurry.
The question is – if you borrow money in order to invest in the stock market, is that borrowed money good or bad debt?
According to the previous rule of thumb, this could technically be classified as good debt. After all, that borrowed money does indeed have the potential to add to your net worth – so long as your investments turn out to be successful (and generate a return higher than your borrowing costs).
Yet, borrowing money to invest in the stock market is universally considered a terrible idea for individuals (and they’re right). Although the return potential is there, the risk is simply too great for most. That risk factor must also be considered when evaluating whether a specific debt is good or bad.
When we apply this factor to home loans, we can thus envision several common scenarios where they can cross the line from good to bad debt. For instance:
- Overborrowing. There’s a term for people who buy more house than they can afford – house poor. They find most of their income going toward loan instalments, property taxes, utilities, and maintenance. The result is they may own a high-value asset, yet still find themselves struggling month-to-month. Here in Singapore, borrowers are limited by a 60% TDSR (and 30% MSR for direct HDBs and executive condominiums purchases). But it can still happen.
- Poor home loan structures. Interest-only mortgages (where the payments would spike after a few years) helped spark the 2008 subprime crisis that soon spread to global markets. This was a poorly thought-out home loan structure that placed borrowers at significant risk if the property market stopped appreciating – even if only briefly. Fortunately, such loan structures have been disallowed in Singapore since 2009.
- Constantly withdrawing equity from the home for consumption. Those with private properties can take out home equity loans (also known as cash-out refinancing) based on the value of the equity in the property. These loans are flexible, meaning you can use the funds however you please. If you constantly take out these loans – which are also a form of home loan – and use them purely for consumption purposes, you are definitely crossing the line into bad debt.
5 Tips for Ensuring Your Home Loan Always Stays on the Good Side of Debt
Debt is not inherently good or bad – it is just a tool. And like any tool, it depends on how you use it. It is also almost impossible for most people to become homeowners without going into debt. The key is taking on home loans responsibly. As long as you do that, it is highly unlikely that your home loan will stray from the good side of debt. Her are five tips for keeping it that way.
Tip #1: Understanding what you are buying the property for
When you’re clear about how the property fits into your life and goals, it’s far easier to ensure your home loan stays as good debt. For instance, if you are younger, yet to reach your peak earning years, and buying your first property that you know is a starter home you plan to move out of within 5 years, it doesn’t make sense to overstretch your budget.
Tip #2: Being strategic with home equity loans
If you already have a private property with equity in the home, you might be tempted to take out home equity loans. Again, it all depends on what you intend to use it for. One of the best ways to use it is for debt consolidation – using it to pay off all your other high-interest debt. In this way, you can actually replace bad debt with good debt.
Tip #3: Never losing sight of affordability
The higher your debt, the higher your risk. This doesn’t mean that the debt itself is bad, but it does mean that you should be aware of how much you are taking on. Affordability isn’t sexy, but it is fundamental to having peace of mind when it comes to your home loans. Our Affordability Calculator is the best place for you to get a baseline assessment of the price of a property you would be able to afford.
Tip #4: Always adding a margin of safety on top
The Affordability Calculator is a good baseline. But you should also always add a buffer on top of that (it goes without saying that this should also apply for the regulatory TDSR limits). Remember that your home loan debt also comes with a host of other related costs, such as property taxes and maintenance, which many forget to fully account for.
Tip #5: Looking before you leap (doing your research)
When it comes to a financial commitment as substantial as a home loan, not doing proper research beforehand is a cardinal sin. Even in the very best-case scenario, you could still end up with a subpar home loan, leading to you paying more interest than necessary. Yes, it may still be good debt – but that doesn’t mean you should be lax about the cost of that debt. Remember that even a 0.1% difference in a 30-year $500,000 home loan could add up to almost $10,000.
Everybody’s Situation is Different…
Although the information and advice in this article is broadly applicable to most Singaporeans, there might be specific nuances to your situation that may mean otherwise. Don’t worry – we got you covered.
All you need to do is head to this page, fill out a short form, and one of our friendly and professional Home Finance Advisors will get in touch with you. You can explain the full details of your situation, and they will give you objective advice tailored for you. For more general – yet still useful – advice, check out the rest of our home financing guides.
Disclaimer: Information provided on this website is general in nature and does not constitute financial advice.
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This article was written by Ian Lee, an ex-banker turned financial writer who hopes to use his financial background and writing skills to help raise people’s financial literacy levels – a necessity in our modern world.