What Type of Debt do You Have? Understanding the Good & Bad When it Comes to Wealth
by Dominique Schuh
We're hearing a lot of commentary at the moment about the relative difficulty in getting a loan now that the banks have tightened their lending criteria. However, further discussion needs to be had on lending in general and the role that debt plays in wealth creation, both good and bad.
You may have heard the terms "good debt" and "bad debt" in the past, and they relate to two quite different scenarios. Bad debt is basically when you use a loan to buy something that loses value over time or doesn't offer you any return on the investment - so no way for you to make money on the purchase.
As an example, a loan to buy a new car is considered bad debt, because the car loses value as soon as you purchase it. Added to this is the concept that any type of interest payment you're not able to claim a deduction on is also bad debt, and in this category, we would include your private home loan debt. In this instance, you need to earn an income, pay tax on that income, and then pay off your interest with whatever is left over.
By comparison, Good debt relates to lending you've undertaken that will give you some kind of return in the future and is also taken out on an asset that will increase in value. Further to that, the interest on the loan is tax deductible. An example of good debt is a loan for an investment property where the property is increasing in value and the interest on the loan is tax deductible.
The key to managing debt is to adopt some of the following principles:
1. At all costs, minimise as much as possible your exposure to bad debt. In practice, this means paying off your home loan as quickly as possible, getting rid of credit card debt and using your savings rather than borrowings for things that depreciate – such as car loans or even furniture.
2. Make sure that your cashflow is sufficient to allow you to continue making your repayments, even if interest rates increase. This means that you need to allow a safety buffer with your level of borrowing. Calculate what your repayments would look like if interest rates lift as much as 1 percent over the life of the loan – can you afford the repayments and does it add time to the length of the loan?
3. Always direct the bulk of your debt repayments towards those loans that are costing you the most in interest. This will usually be credit card debt first, followed by personal loans and car loans, then loans attached to property. Student loans are usually the cheapest and can be left until last.
4. Where possible, consolidate your debt into a single manageable amount.
5. Debt consolidation involves rolling all your existing debts into one loan. This may help you to better manage your repayments, but it may also make your situation worse if the interest rate or fees in the new loan are higher than they were with your original debts.
Before you consolidate anything, these are some things you should do before you sign any debt consolidation loan contracts:
1. Compare the interest rate, fees and charges - Make sure you will be paying less for your new loan by comparing the interest rate, including fees and other costs, against your original loan. Some lenders charge penalties if you pay off loans early and some charge application and legal fees, valuation and stamp duty if the new loan is secured against a home or other assets.
2. Check the terms - Beware of longer loan terms. Even if the interest rate is lower on the new loan, paying off a short-term debt (like a credit card or personal loan) over a very long term means you will still pay more in interest and fees.
3. Check the company is licensed - Lenders and brokers that are not licensed are operating illegally. Search ASIC Connect's Professional Registers to check your lender is licensed.
Remember we're only a phone call or email away if you'd like to discuss any of these ideas in more detail.