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Good debt versus bad. What’s the difference?

Australians today are carrying more debt than ever, with the average household debt in 2016 sitting at $245,000. This has quadrupled over the last 30 years, putting our debt level at the fifth highest in the world (according to Canstar).

Low interest rates, low unemployment and a strong economy are all reasons for our bullish attitude toward debt. Plus, having some credit card or personal loan debt these days is practically unavoidable. It seems you need to have had at least a little bit to get ahead – lenders typically won’t give you a mortgage unless they can see your credit history.

But not all debt is bad, it doesn’t all eat away at your wealth. In fact, some debt can make you wealthier. The key is to understand the difference between good and bad debt, and ensure you don’t get stuck with high interest loans on unsecured or depreciating assets that you can’t afford.

So what makes some debts good and others bad?

Putting it simply, good debt helps you to generate wealth. The idea behind good debt is that you borrow money to invest in something that will grow in value over time. The capital appreciation of the asset should outweigh the interest and taxes you pay over the period of the loan, leaving you in a net positive position when you go to sell.

Good debt

An example of good debt is a loan on an investment property, where you borrow money to purchase a property to rent out to tenants. The rent you receive from the tenants goes toward repaying the loan.

In instances where the rent received is less than the loan repayment, you will need to make up the difference. This is called negative gearing. While you will be out of pocket in the shorter term, if you’ve made a good investment, the property should go up in value as time goes on. In other words, the money you make from the capital growth should be more than the loss you make in rental shortfall. The Australian Taxation Office allows you to claim a tax deduction for expenses incurred in earning investment income, so this difference in the loan repayments can be claimed as can other associated expenses like repairs, insurances and rates.

Investment properties don’t have to be negatively geared, they can also be positively or neutrally geared. Positive gearing is where you purchase a property that generates more rent than the loan repayments, while neutral gearing is where you purchase a property that generates the same amount of rent as the repayments. These kinds of property can be harder to come by.

Many people debate whether a mortgage falls under the ‘good debt’ category, since it is not making you an income while you are living in the home. You may be in a net positive position when you go to sell your home over the longer term, due to the rise in property prices, but this is never a guarantee as property can fluctuate like other asset classes.

Bad debt

Bad debt typically carries a high interest rate and is used to purchase a depreciating asset, things that lose value over time like a car. Credit cards and personal loans (both secured and unsecured) are considered bad debt.

Since bad debt is eating away at your wealth you want to get rid of it fast. If your credit card offers an interest-free period, you should try to pay it off during this period before the steep interest kicks in.

One of the simplest ways to get rid of bad debt is to budget, making sure to set aside as much money as possible each pay period to pay down the debt. This requires discipline, so think of it as a fixed cost that must be paid each period. If you’re paying off a credit card, stop using it and set up your repayments as a direct debit.

It is also a good idea to work out which of your loans have the highest rate of interest. Pay more off those while still making minimum repayments on your good debt. For instance, if you have a mortgage, an investment property loan and a credit card you might look to prioritise your debt repayment in the order of:

  1. credit card
  2. mortgage
  3. investment property.

This is because your credit card is bad debt, likely charging a high interest rate and therefore eating into your wealth. Your mortgage is not ‘bad debt’ per se, and would carry a lower rate of interest, but your home is not generating you an income so you’d probably prioritise this next. And because your investment property is contributing to your wealth, you might look to set your repayments on this loan to interest only, to free up your money to focus on paying the other debts down first.

Debt consolidation is another way to pay down bad debt. It means using one loan to pay off many others. If you have several credit cards or store cards you might consolidate them into one, lower interest rate personal loan – or use your mortgage – to repay them. That way you have one easy, manageable monthly repayment.

Financial advisers can help you to reduce your bad debt and give you strategies to use good debt to your advantage. If you are in trouble with debt repayment, there are a number of resources available to you. Visit ASIC’s Moneysmart website for more information.



Image credit: ©Viktor Solomin via Canva.com