MANAGING DEBTS IN A RECESSION

During an economic slowdown, it is important to be as financially stable as possible, and having a lot of debt is a hindrance to stability. In this article, we take a look at some of the ways to pay down a great deal of debt in a short time.

Being neck-deep in debt is one of the worst financial situations to be in and the risks could be further compounded by the credit crunch or the danger of losing one’s income in a recession. There are some possible ways to help our clients manage their debt repayments to avoid further financial hardships during a recession, such as through managing mortgage repayments and credit card debts.

Mortgage Loans

i) Refinancing
Clients who are financing their homes with bank loans and are already free from any lock-in period can consider refinancing their bank loans, given the low Singapore Interbank Offered Rate (SIBOR) now which currently stands at 0.69 percent compared to 2.22 percent in Septemberi last year.
Many fixed interest loans taken up a few years ago would likely have interest rates of above three percent. By refinancing to a SIBOR-linked package, that interest can potentially be reduced. However, the banks’ margin spreads against SIBOR are increasing in recent times. Even though the rates for SIBOR-linked packages are still very competitive, those who are looking to refinance should do so before they miss the current opportunity. Advisors should warn clients of the volatility of such SIBOR-linked home interest rates as well as the potential costs involved in refinancing. One should only make this move when the potential gains are weighed against the risks and costs.

ii) Interest-only home loans and loan restructuring
For those who might be cash-strapped, a local bank is offering an interest-only home loan for up to 18 months to help them copeii in this recession.

For example, a 20-year home loan of S$400,000 with an interest rate of 3.5 percent per annum will yield different monthly loan repayment rates depending on the type of home loan.
(see Table 1)

Table 1

	Monthly Loan repayment for regular home loan	Monthly Loan repayment for intrest-only home loan
20-year home loan of S$400,000 at an interest rate of 3.5 percent p.a.	S$2,320	S$1,167*

*Up to 18 months

Table 2

	Monthly Loan repayment for 20-yr home loan	Monthly Loan repayment for 30-yr home loan
Home loan of S$400,000 at an interest rateof 3.5 percent p.a.	S$2,320	S$1,797

Some banks allow borrowers to restructure their loans. For example, monthly repayments can be reduced by increasing the loan tenure. Table 2 above shows that there will be a lower monthly repayment rate when the loan tenure is extended from 20 to 30 years.

Even though interest-only and loan restructuring features are applicable to all borrowers, we should remind clients not to take such measures unless absolutely necessary. By paying interest-only loans or by extending the loan tenures, borrowers will end up paying much more interest on their loans in the long run as they are taking a much longer time to make capital repayments.

iii) Paying down mortgage loans
Overall, housing prices have fallen 6.1 percent in the last three months of 2008iii. Some homeowners now owe the banks an amount more than the value of their properties. It was reported that the proportion of DBS home loans in negative equity jumped 50 percent to 0.6 percent in December 2008, reflecting the rapid deterioration in property pricesiv.

With negative home equity, homeowners could face difficulties refinancing their loans as most banks are only willing to lend up to 80 percent of the property market value. Homeowners who want to sell their properties may also find that they have to cough up extra cash to repay their loans. Those with the financial ability should pay down their home loans as much as they can. They can either do lump sum capital repayments if there are no penalties for early repayment or opt to pay more for their monthly instalments over shorter tenures. That way, they could save on interests as well as reduce the risks associated with negative home equities.

Credit Card Debt
Credit card debts now stand at approximately S$5.1 billion – an increase of about 35 percent over the past two yearsv. Almost 40 percent of credit cardholders roll the payments over each monthvi.
If a revolver makes only the minimum payment (three percent of outstanding bill) on a S$5,000 credit card debt with a 24 percent charge, it would take 325 months to fully repay the debt with interests amounting to S$9,560.

i) Making a fixed amount repayment and repaying more than the minimum amount
By maintaining a fixed payment of the initial minimum amount of S$150, the repayment period will be shortened to 56 months and the interest will be reduced to S$3,323. And if one can pay a fixed amount more than the minimum amount, say S$240, then the repayment period will be halved and the interest reduced to S$1,533! (See Table 3)

Table 3

S$5,000 credit card debt at 24% p.a.	Paying only the minimum repayment	Paying a fixed admount of S$150	Paying a fixed amount of S$240
No. of months it takes to clear debt	325	56	28
Total interest paid	S$9,560	S$3,323	S$1,533

ii) Balance transfer
Debtors hoping to seek temporary reprieve can consider doing a balance transfer which is offered by many banks and often at promotional rates of zero percent lasting six to 12 months. For a credit card debt of S$10,000 at 24 percent interest, a transfer to one of the local banks at zero interest for six months will help save S$980. Table 4 below shows how the savings are calculated:

Table 4

Balance Transfer of S$10,000 at zero interest for six monthsPaying only the minimum repayment
Interest from other banks’ credit cards at 24 percent p.a. for six months	S$1,200
Interest at zero percent p.a. for six months	S$0
Administrative fee at 2.2 percent for six months	S$220
Savings	S$980

While balance transfer could help save on interest in the short term, any debts still outstanding after the promotional period will be charged the prevailing rate of 24 percent per annum. One should also take note of the processing fees of between one to five percent as well as penalties involved for late payment or premature account closure.

Overall, balance transfer is a plausible strategy for those who can afford to repay their debts in full within the promotional interest period as it helps save on interests. But for those who are not disciplined in repaying their debts, transferring their debts from bank to bank will only cost them more in the long run as there are charges involved in every transfer, which would add on to their existing debts.

Debt Repayment Strategies
For a person with multiple debts, most advisors will advocate paying off the debt with the highest interest first. This method makes most financial sense as it will minimise the total amount of interest paid. However, psychological factors can undermine the success of this method especially if the highest interest debt is huge and it would take very long before one can experience the joy of having one less debt to worry about. Given that debt repayment is often a long arduous process, it is important to ensure that the debtor continues to stay motivated for the plan to work.

In this scenario, there is another school of thought which is to pay off the smallest debt first. This debt-snowball method is made popular by Dave Ramsey in his book, The Total Money Makeovervii. With this method, the debtor will pay as much money as possible towards the smallest debt while making only minimum payments on the rest. Once the debtor quickly clears off the smallest debt, the money meant for the earlier debt will then be used to repay the next smallest debt and so on. The debtor is more likely to stay motivated as his action is more quickly rewarded and it would reinforce his desire to keep up with the debt payment.

While this method will cost more in terms of interest payable over the long run, the likelihood of success in making one stick to the plan makes it a worthwhile consideration, especially for those who always experience difficulties in clearing their debts.

Conclusion
Our clients can be free of debts if we can help them adopt some of the abovementioned strategies. As soon as they see their cash flow situations improve over time with better debt management, we must remind them not to repeat the same financial blunders that got them into trouble in the first place. By performing the cash flow analysis at the initial stages of our discussions with them, we can try to detect patterns of overspending, if any, and provide them with timely advice before it is too late.