Your networth is a balance sheet listing your assets and liabilities. The difference for both is called the net worth. However, the net worth or balance sheet contains many “off-balance sheet” items. Today, I’ll write about the most common off-balance sheet item. I will give an example:
Let’s say your net worth is as below:
Assets
Cash $30,000
Property $400,000
Liability
Mortgage $200,000
Net worth $230,000
Let’s assume that your cash inflow (or your income) is $80,000 per year. Assuming your mortgage installment is $1,894.51 or $22,734.08. This is based on 2.6% per annum interest, 10 years installment monthly rest.
The debt-to-asset ratio is total liability / total asset = 200000/(30000+400000) = 46.51%. Normally it is recommended that this ratio should not exceed 50%.
The debt-service-ratio is loan installment / total income = 22734/80000 = 28.42%. Normally it is recommended that this ratio should not exceed 35%.
Now, what happens if you have entered into a long-term contract saving plan such as an ILPs? Let’s say you bought an ILPs to save $1000 per month for 25 years N=25*12, PMT=1000, R=6%/12, the present value of this obligation is $155,982.90. Why is it an obligation? It is because once you entered into a contract, you have a contractual obligation to pay for this premium. Let’s say that the present value of the benefit you will get at maturity is also the same as your obligation. To recalculate these ratios we will need to add the assets by $155,982 and liability by $155,983.
Thus, the adjusted debt-to-asset ratio is total liability / total asset = (200000+155982)/(30000+400000+155982) = 60.75%%.
For adjusted debt-service-ratio is loan installment / total income = (22734+12000)/80000 = 43.42%.
Both ratios have increased significantly and have breached their respective recommended thresholds. The larger the debt-to-asset ratio the greater the amount of debt that a person has. What this means is that if you want to say borrow more money to upgrade your property, you are making a very dangerous decision because you are already greatly indebted. The higher debt-service-ratio is an indication of the amount of cash flow being locked up to service a loan. While it is not possible to go bankrupt by stopping the premium for an ILP, the huge capital lost is a significant deterrent to prevent you from stopping the ILPs.
This analysis is quite representative of the economic reality of entering into a long-term contract saving plans such as an ILPs:
- You cannot commit more money into buying a property since you are already committed so much money into the saving plan;
- You will think twice stopping work to upgrade your education since you have to worry about servicing the ILPs;
- You may not have enough cash flow on hand to have another child;
- I have a friend who wanted to stop work to look after her children on a full-time basis. But she cannot do that due to too much commitment into “saving plans.”
- If you are not careful, you could end up working all the way to your 70s just because you need to service your long-term saving plans.
Just to clarify, saving plans aren’t just ILPs. It could be an endowment, anticipated endowment, 3G insurance, whole life, whatever. As long as there is a long-term obligation to pay regular premium, the above analysis applies.
Saving plans are meant to benefit the policyholder. You should not be working for your saving plans. Your saving plans should be working hard for you. My advice is that you should not enter into an unreasonable large amount of money into saving plan. If you just do RSP into say a unit trust, there is no obligation to continue servicing it since there is no contract. The problem is that the commission for unit trust is getting so low that many financial advisers prefer to sell those ILPs that pay them the entire period’s worth of sales charge upfront. Unfortunately this means locking their clients to long-term contract. The irony is that you cannot achieve your financial independence because you got yourself into the obligation to work for your saving plans.
Here is a related article which you may interested in: What is the difference between savings and investments?
This blog article was published in CPF Board's IMSavvy / IM$avvy: http://www.cpf.gov.sg/imsavvy/blog_post.asp?postid=900645782-71-8936055301
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