How to avoid the debt trap: Here's 5 rules to follow

 Money packets in the form of Singapore currencies, being sold at a Ramadan bazaar in Geylang Serai on Aug 16, 2012. PHOTO: BERITA HARIAN
Money packets in the form of Singapore currencies, being sold at a Ramadan bazaar in Geylang Serai on Aug 16, 2012. PHOTO: BERITA HARIAN

SINGAPORE - The Monetary Authority of Singapore is clamping down on consumer debt, announcing on Monday tighter limits on the amount of unsecured debt that borrowers can hold. Unsecured debt is borrowing not backed by any collateral, such as credit card debt and personal loans.

At the same time, the Association of Banks in Singapore and Credit Counselling Singapore unveiled a new repayment assistance scheme to help those over the limit to cut their debt by allowing them to repay the excess debt at a lower interest rate.

But how can we avoid the debt trap in the first place?

The Straits Times spoke to Mr Alfred Chia, chief executive at financial advisory firm SingCapital Pte Ltd, who gave these five rules to follow:

1. Distinguish needs from wants

In Mr Chia's experience, many people incur excess credit card debt through overspending because of their inability to tell needs from wants. He raised the example of a handbag, pointing out that while one may need a bag for daily usage, one only wants a luxury bag costing thousands of dollars.

2. Prepare for emergencies

Mr Chia noted that while some people fell into debt through overspending, others had been trapped by emergency needs such as medical bills, particularly those without appropriate insurance coverage.

3. Invest wisely

Still others had lost money to poor investment choices and found themselves indebted, said Mr Chia.

He warned investors against using their credit cards for investments as it is risking borrowed money. Also, he advised investors to gain a good understanding of the investment product and of the risks they were willing to take before making any investment.

4. Don't count your chickens before they hatch

Mr Chia pointed out that many people fell into the trap of "spending future money". They relied on expected sources of income such as bonuses and pay increments to finance future repayments, only to find themselves deep in debt when those sources were unexpectedly cut off.

He also noted that even debts that initially seem manageable may rapidly "snowball" because of compounding interest, which he said was at an average of 25 per cent.

5. Use the 4321 formula

Mr Chia prescribes a formula of 4321, which he also abbreviates as LESS:

- Loans, including housing, car and credit card loans, should not exceed 40 per cent of one's income.

- Expenses should not exceed 30 per cent of one's income. They can be covered with credit cards, but these should be paid off every month.

- One should save around 20 per cent of one's income on long-term financial goals such as marriage and retirement planning.

- One should save around 10 per cent of one's income for insurance coverage for oneself and one's loved ones.