You may have heard the terms good debt and bad debt before, but it is not as simple as labeling credit card debt as bad, and a home loan as good because a home loan can in fact be considered bad debt too.
It is important to understand the differences between and the definitions of good debt and bad debt so you know how to manage each when they come into your life – and they will.
However, if you know what to look for and what to do, you can be in control of both good and bad debt in your life, and you can win the debt battle.
What Makes Debt Good or Bad?
There are endless opportunities for you to get into debt every day whether it be a purchase at the mall, a dream house or a hot investment tip you want to follow, but before you follow anything, know what you are getting yourself into.
Is traditionally thought of as debt on an asset which will increase in value over time and benefit from compounding. This is actually a simplistic view of good debt because even a mortgage on your home, a house which is increasing in value, can be bad debt because you are paying it with your after tax dollars.
- Good debt is paid with pre-tax dollars. Good debt will be tax deductible which means that the money you have borrowed to buy an investment property or shares is a good debt. This is because the interest you pay on that money can generally be deducted from your overall taxable income, possibly putting you into a lower tax bracket where you can pay less tax at the end of the year.
- Gains from good debt can be taxed. The capital gains you make from your investment property or the shares you have borrowed (margin loans) to invest in can be taxed, but as you just learned in the point above, the money you borrowed to make those investments is tax deductible so your good debt evens itself out and keeps you ahead.
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- Will not increase in value. This means anything you buy on your credit card which is a consumable such as clothes, shoes or electronics is simply adding to your bad credit card debt as none of it will increase in value.
Your car loan. Getting into debt to buy a car, especially a new car, is accumulating bad debt as cars are notorious for losing almost half their value as soon as they are driven out of the dealer’s lot. Plus, there is a very small chance that you will be able to sell your car for more than you bought it, making it a depreciating asset.
- Is paid from your after tax income. This includes interest payments not only on your credit cards and store cards, but your home loan too and because the payments are made from your after tax income, they are more expensive and therefore bad for your finances.
How to Balance Good and Bad Debt
While there are good debts and bad debts, there are also varying degrees of good and bad and you have to weigh up the costs of a bad debt with your needs, while making sure that the leverage on your good debts is at a comfortable level for you now, and for any possible changes – like interest rate rises – in the future.
How to manage your debts:
- Don’t just avoid bad debt and stock up on the good. While a home or car loan are classified as bad debt, they are also necessities for most people and so if you are able to manage your repayments and have a plan to pay off those debts as soon as possible you can have control over your bad debt, and have a nice home and car too. Plus, bad debt in the form of a home loan may be costing you tax dollars but even though you are paying your interest and repayments with your after tax dollars, your home is still likely to be increasing in value – this is where the degrees of good and bad debt come in, and sometimes there is grey debt.
- Don’t save in lieu of debt. For most people it would take most of their lives to save up the money they needed to buy their home outright, so while saving makes good financial sense, your savings balance often doesn’t give you the leverage to get what you want in life, that a loan can. Using the home example again, in getting a loan on your first home you can live in it while it appreciates in value and then use that as leverage to move onto a bigger and better home, rather than having to spend years and years saving and scrimping.
- Make your money work for you. By investing in good debt which is paid from your pre-tax dollars you are making your after tax money work harder because there is more of it. Plus your invested money is working hard for your after you’ve worked hard to earn it because your asset is expected to keep increasing in value.
Leverage your good debt. Leverage is also related to the amount of money you have invested, as compared to the value of the investment. For example, if you have borrowed 95% of the value of an investment property then you are highly leveraged and are more likely to be affected when interest rates rise and your repayments follow. However, being highly leveraged also means that more of your money is invested and more of your money which is directed towards your good debt, securing you more tax benefits.
- Pay off your bad debt before your good. Focus your repayments on reducing your bad debt such as credit cards and personal loans and pay only the minimum required on your good debt.
- Pay off your higher interest rate loans first. It is important to know your repayments and your interest calculations on all your debt and loans – good and bad. You can then pay down the loans with the higher interest rates first and get yourself out of debt all together, faster.
- Make sure you borrow for appreciating assets. If you have a dream of owning your own home, don’t abandon it because it is considered bad debt, just make sure that your asset will continue to increase in value, and don’t over commit yourself.