Good Debt vs. Bad Debt

You’ve definitely heard of ‘good’ versus ‘bad’ debt before… but perhaps you are not sure what it means, or how to benefit from ‘good’ debt.  Let us break it down for you!

Note: this blog post is aimed at private investors (i.e. you guys), not corporate entities (i.e. companies or small businesses).  Corporate ‘bad debt’ is different again (let us know if you’d like to see a separate blog post on this issue).

 

Bad debt

Firstly, the most common, bad debt.  Bad debt is debt that attracts no tax deduction and is not used for tax purposes. This includes your home loan, credit cards, personal loans, car loans etc. that are used for your personal consumption or living.

These are NOT tax deductible and have interest costs that make the item you have purchased more expensive the longer you hold on to the debt.  For example, if you go on $10,000 holiday and fund it on your credit card (with an interest rate of 20%), the holiday will cost you the initial $10,000 plus the interest cost of $2,000 per year until it is repaid. Expensive holiday!

The same principle is true for your home loan – except the numbers and interest costs are much higher (sometimes the interest over a 30 year term can exceed the purchase cost of your house!)  This is why financial planners are always banging on about paying your home off as fast as you can – because every year you don’t, the debt is getting more expensive.

 

Good debt

Good debt is tax deductible debt that is used to invest and generate an income that helps to repay that debt. An example would be an investment property loan. The beauty of this debt is that the investment asset generates income (rental income or dividends) which can then be used to supplement the cost of the loan. This type of debt is often held for a shorter amount of time, as you are able to use rental income as well as personal income to meet the repayments. The other benefit of having investment debt is that the investment should increase in value.  Generally you should only borrow money to invest in assets with capital growth potential.

But what do the numbers say?

Using a case study of a couple with $400,000 debt, the red bar on the right shows the bad debt costs.  These are the yearly interest cost of having a home loan ($16,000).

Alternatively, if that $400,000 was being used to fund an investment property (with a 3% rental yield) and applicable tax deduction, the cost of holding that debt is only $2,620 per year.  That means that you can hold more than 5 times more ‘good debt’ ($2,000,000) than ‘bad debt’ (namely because of the tax treatment and also due to rental income from properties, which you do not get for a home loan).

You can’t just can’t snap your fingers and convert to good debt – it needs to be part of a long term plan with your end goal in mind.

This blog post highlights good financial patterns and suggests which debt to pay off first.  If you are struggling with your cash flow or don’t know where to start, please contact us to book in a free consultation on 07 4646 4970 or at info@fortressfs.com.au

 

Written by Chris Black, Director of Fortress Financial Solutions

Fortress Financial Solutions founder Chris Black is an award-winning financial planner based in Toowoomba who specialises in superannuation, investing, business succession, cash flow management, retirement planning and personal insurances (including life insurance, income protection, total permanent disability and trauma insurance).

Corporate Authorised Representative of Magnitude Group Pty Ltd ABN 54 086 266 202, AFSL 221557.

Information on this site may be regarded as general advice. That is, your personal objectives, needs or financial situations were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of any general advice we have given you, having regard to your own objectives, financial situation and needs before acting on it. Where the information relates to a particular financial product, you should obtain and consider the relevant product disclosure statement before making any decision to purchase that financial product.

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