Good Debt Bad Debt
By: Lisa Farnell
Tags: Money Management, Debt, Money, Wealth, Wealth Management

Not all debt is created equal and it’s essential you learn the difference.

Photo by Daniel Thiele on Unsplash

Debt is not a dirty word, but many of us grew up thinking it was to be avoided at all cost. My parents had a mortgage to buy the family home that they dutifully paid off. They never borrowed for anything else in their life.

On the one hand, this is good. They didn’t have debt for things like cars that depreciate over time. On the other hand, they didn’t use debt to get ahead financially.

What is debt?

Debt is basically money that you have borrowed from someone else to buy something. You have to repay this money over time and the person who lent it to you usually charges you interest as their reward for lending it to you.

A debt might be a loan from your Mum, a credit card, payday loan, a car loan, store credit, a business loan, a home mortgage, an investment property or other investment loan. One thing is certain… not all debt is created equal.

Let’s talk good debt

Good debt is effectively for anything that is likely to appreciate in value and generate income. In Australia, you get a tax deduction for the interest cost of borrowing to offset the income tax payable on the income you generate from the investment.

In addition to the income, the capital growth of the investment also means your equity in the investment grows over time. An example. If you borrowed $100,000 to buy a property for $150,000, your equity in the property is $50,000. If the debt stays at $100,000 but the value of the property goes to $200,000, then your equity has grown to $100,000.

Borrowing money to invest in a rental property (residential, commercial, retail or industrial) represents good debt. The investment generates regular income in the form of rent, to help in paying off the debt.

The same goes for taking on debt to buy shares (stocks) or managed funds. The dividends or distributions paid help with repaying the debt, whilst the share price grows over time.

Using debt to start a business is also an example of good debt. In addition to the possible tax benefits it provides, it may well be the only way you can get the business off the ground.

Beware though: in all these examples it’s great when the value of the asset is going up, but it can also go down. Although you will still generate income, there is a chance your investment will fall in value, sometimes below the price you paid for it (whilst your debt remains the same). This isn’t a reason to not do it… just be sure you understand all the risks.

Photo by Austin Distel on Unsplash

Investing in yourself and your education can be good debt. If this is going to help you hustle out into the world and make some coin then it’s worth the investment. Just be sure it isn’t a form of procrastination!

In Australia, you essentially borrow money from the Government to pay for your University fees and then start paying it back when you are earning a certain amount of income. The interest rate on this is really low and you have a very long time to pay it back.

Negative gearing basically means you are paying more interest than the investment returns (ie: you’re losing money). This may be a good thing if you get a tax deduction for the interest cost or the asset is likely to go up in value.

OK Debt

OK debt is neither good nor bad really. Borrowing money to buy the family home, to me, is an example of OK “middle of the road debt”. The family home doesn’t generate income and there are generally no tax perks associated with the family home, so in this sense, it is bad debt. On the plus side, the home is usually an asset that will appreciate in value over time so that’s a good thing. Borrowing for the family home is really a lifestyle as much as an investment decision so just pay it off as quickly as possible!

When it comes to buying the family home, may people go to the bank first to see how much they can borrow and then start looking at houses in that price range. A better approach would be to figure out what you actually need in a house an start looking there. Generally what people need is a lot less than what the bank will offer to lend them.

Bad debt

Bad debt generally has a very high interest rate attached to it, often has fees associated with paying it off early, offers no income or tax benefit and is usually for an asset that depreciates over time. This often means that the price you pay in the end is a lot more than the asset is worth.

Examples of bad debt are cars (with the exception of those owned by a business perhaps), credit cards, payday loans, and store credit; especially if they aren’t paid off in full by the due date. Annual interest rates can be ridiculously high with store and credit card rates between 12–18% and payday lenders up to 30%.

Photo by StellrWeb on Unsplash

Let me show you how that works: if you have a credit card debt of $10,000 with a 15% interest rate, and you just pay the minimum each month, it will take you 28 years and $12,000 interest to repay it. That’s $22,000 to buy $10,000 worth of stuff that you probably don’t own anymore.

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it.” Albert Einstein.

If you don’t have the money, don’t buy it. As the saying goes; Don’t buy a $500 bag and have nothing in it… Buy a $50 bag and $450 in it. Don’t go broke trying to look rich.

My final thoughts on debt are that all debt reduces choice and flexibility. If it is helping you get to where you want to be that’s great. But for many, they end up working to service debt (often just to get a tax deduction) rather than getting to a point where they have the choice to reduce hours, or change to a lower-paying job they love.

It represents an opportunity cost.

What now?

Look at your current debt position and put it in 3 columns: good, bad and ok.

Look at your budget and how you can factor in extra repayments to start knocking it over. Tackle the bad debt first, then the home loan and then finally the good debt.

Finally, consider debt in this light before you sign up for debt again.

Good luck with it.