Australians have broad attitudes when it comes to debt. Some enjoy living from moment to moment, funding spectacular lives through credit cards. Meanwhile, others utterly fear debt and will strive to avoid all possibility of it. Since Australian households are the most indebted among the world’s rich countries, running at an average of 1.9 times their income, it’s important to have a good understanding of debt.
While it’s possible to go through life debt-free, it’s not necessarily smart. Many of us cannot afford to pay for life’s most important purchases upfront – from a home to a car to a university education. Before taking out a loan or buying on credit, it’s important to know whether the debt incurred is good debt or bad debt.
Put simply, good debt is an investment that will grow in value or provide long-term income. Bad debt is when you borrow money for goods that depreciate in value and/or provide no income.
Good debt is a loan that is used to acquire assets that provide you with a return on investment. These investments should be strategically acquired so that they generate an income and/or go up in value.
Good debt should supplement the cost of the loan and actively help you to build long-term wealth. In other words, you’re better off with it than without it.
Borrowing money to purchase a home is a good debt because the property is likely to increase in value. When you sell the home, it will not be subject to the capital gains tax imposed on investments.
An Investment Property
Taking out a home loan to purchase an investment property is a great example of good debt because it generates income, increases in value and the interest expenses are tax deductible.
The debt will generally be held for a short time because it can be paid off by your personal income as well as income generated by the property through rent or dividends.
Most university students take on a HECS debt to pay for their degrees, which cost an average of $50,000. It’s considered a good debt because there is no real interest and students benefit in the long run from a higher income job.
There is also an income threshold before repayments have to be made, which is adjusted every year (currently $54,869).
Bad debt is the more common kind of debt, covering credit used for personal consumption or living with an interest that is non-deductible. Bad debt doesn’t generate income and any assets purchased depreciate in value over time. Examples include:
Credit Cards or Personal Loans
Borrowing money to buy consumer goods, pay for daily expenses or go on holiday is a cost that isn’t worth anything financially and becomes more expensive the longer you hold onto the debt.
For example, if you went on a $5,000 holiday funded by your credit card with an interest rate of 20%, it will cost you the $5,000 plus an additional $1,000 a year until it is repaid.
Borrowing a lot of money to buy an expensive car is a prime example of bad debt. A car rapidly and consistently reduces in value once you own it, with an average value reduction of 19 per cent in its first year of ownership. Additionally, the average running cost of a car is approximately $8,000 a year in Australia.
If you buy a new car for $25,000, it will be worth $20,250 after one year. With an interest rate of 10 per cent, the yearly cost of the car combined with running costs comes to $10,500 until the debt is repaid. That’s a loss in value of $15,250 after just the first year.
How to Manage Debt
You can’t always avoid incurring some form of bad debt. The key is to minimise it and develop a financial strategy that puts you in the best possible situation before getting a loan. Pay off bad debt first to minimise expenses from interest. You can also refinance to roll all your loans into one or achieve a better interest rate or payment plan.
Remember that good debt can come with risks as well. The advantages and consequences of taking on good or bad debt often come down to personal circumstances. It can also be influenced by events out of your control such as supply and demand, interest rates and rental demand.
The information in this article should not be taken as financial advice. If you need professional financial advice in New South Wales, get in touch with the friendly team at Kaboodle Finance. We can provide you with a personalised strategy and practical, easy to understand advice about home loans, mortgages and debt consolidation.