Within financial circles many advisers and commentators regularly talk about the negative aspects of bad debt and positive approaches to good debt.
But to many the difference is a mystery – isn’t debt just debt?
Lets first consider what good debt is. Good debt is referred to as that debt that assists in building net worth through either income and / or the holding of an asset that will appreciate in value. This type of debt could also often be tax deductible.
An obvious debt that is considered good debt is an Investment Home Loan whereby the debt assists with purchasing a residential property that is expected to generate income ( i.e. rent) and hopefully overtime the asset (house) value will increase in value.
Another example would be a student loan as the cost incurred is potentially generating higher earning potential in the long term for the student.
Some even consider debt against the family home as good debt as it reduces the need to pay rent, while historically we can expect the value of the home to increase over time. But ultimately this is still a debt
So, by comparison bad debt is that debt that is utilised largely for lifestyle, or consumer purposes. These purchases are unlikely to generate income or be an asset that will grow in value.
Examples of bad debt are a little more obvious – it is that high interest credit card debt that was utilised to purchase lifestyle ‘wants’ rather than ‘need’.
Or, the holiday you took last Spring utilising a personal loan. I can’t think of anything worse than still paying off a holiday years after you have enjoyed the experience!
While many of us need motor vehicles for day to day living, I also view any debt utilised to purchase a car as a bad debt. While many will argue with mean I view the vehicle as a depreciating asset, and many borrowers have been caught with a loan greater than the asset (car) value when it comes time to sell. That is without even considering the cost of interest incurred over the life of the loan.
Something to think about.
Regardless of whether we classify debt as ‘good’ or ‘bad’, the fact is that debt is debt!
Certainly if you hold both ‘good’ and ‘bad’ debt I would suggest that in most situations your primary focus should be to reduce the bad debt as soon as possible as a very high priority.
But even when our focus is creating debt to generate longer term wealth we need to have a balanced approach. Repayment of debt to reduce interest expense and build a stronger net worth position is considered a sound strategy.
Professional advice should also be sought before taking out investment debt. Any debt carries risk, and taking out a loan to purchase an asset may provide opportunities to accelerate your net worth (i.e. income and capital growth exceeds loan cost) but it can also amplify losses. What if the asset you purchased falls in value? In the past this has happened to many share investors who have leveraged their portfolio with debt to purchase more shares, only to see the share market fall.
Some final thoughts
To build wealth, and the lifestyle we desire, often requires debt.
However there are some principles I believe are worth standing by when it comes to debt :
- Never purchase lifestyle items via a credit card, unless you have the savings available to pay the credit card off when the statement is received.
- Always try to utilise savings to purchase depreciating assets such as motor vehicles
- Focus on paying off bad debt as quickly as possible as your first priority
- If you consolidate ‘bad debt’ into your home loan to reduce interest costs, make sure your repayments are increased to ensure that portion of debts is paid off quickly. You don’t want to pay a car loan off over 30 years!
- Get professional advice before considering investment debt, to make sure it is in line with your wealth creation strategy and goals.
- Just because a debt is tax deductible it doesn’t mean it shouldn’t be repaid as soon as possible. Repay the debt to create more equity and wealth that has the potential to be geared up against to purchase a new investment asset.
- Once you have housing debt, consult with a lending professional at least every two years to make sure your loan terms remain competitive
- Wherever possible make more than the minimum repayments on your loans to pay them off sooner.
What are your key principles when it comes to debt? Comment below.
Photo by; Alice Pasqual on Unsplash