Debt – the good, the bad and the ugly

It’s no surprise people try to enjoy the present day, but at the same time also want to invest for their future. Often debt plays a pivotal role in this journey.  For many people, debt is a dirty word. But we need to remember that not all debt is created equal. There’s good debt and there’s bad debt, and then there’s the good debt that can get pretty ugly if it’s not managed properly. Learning to use debt intelligently can make all the difference to a person’s bottom line.

So what’s “good” debt?

Debt is considered good when it helps someone buy wealth-building assets. That can be an asset that grows in value over time and /or provides you with income. Shares and property are regarded as growth assets because, when chosen well, they should grow in value over time. Shares can also offer regular dividend income while investment property provides rental income. In both cases, the income received can be used to help meet your loan repayments. And, don’t forget that in many instances tax deductions can be claimed on the interest paid on an investment loan. Interestingly, borrowing is often referred to as “leverage”. This is because it can help people to get more for their money.

And what’s “bad” debt?

Debt is bad for someone’s wealth when they borrow to buy assets that fall in value, don’t provide any income and are not tax deductible. A typical example of this would be using a credit card or a personal loan to pay for holidays or expensive toys. The trouble with bad debt is that people can often be paying for it long after the holiday has worn off or that new car has halved in value. Also, if bad debt is on a credit card, then it can be all too easy to let the debt roll over each month. Because of the high interest rates that apply to credit cards, initial debts can balloon and take many years to clear.

When bad debt turns good

Used well, bad debt can be put to good use. If credit cards are paid off in full each month this can help manage your cash flow. It might also allow the ability to leave money sitting longer in a high interest savings account.

When good debt goes sour

Using good debt to pay off bad debt can also be problematic. If for instance, debts are consolidated by increasing a mortgage, then the cost of a holiday could spread over 20 years or more, dramatically increasing the total interest payments.

The family home

Buying a home to live in does not provide someone with income but it can still be regarded as good debt. Not only is it a form of enforced saving but in time it may also be used as leverage to fast track wealth creation.  Once equity in a home is built up this can be used as security to take out an investment loan. Then any income earnt from investments— “good” debt — can be used to make extra repayments on the home mortgage. This can accelerate paying off the home loan and freeing up cash for more investments.

A power of good

Whether debt is good or bad, it’s generally wise to clear it as quickly as possible. Bad debts should be paid off first – beginning with the debt that has the highest interest rate – as there should be advantages with tax concessions available on good debt.

In years gone by it was common to wait until you people have saved up for what they wanted. Nowadays the ease of obtaining credit can lead to reckless behaviour. But there’s still an important place for good debt.

Given most people spend many years in retirement and would like to be self-funded, borrowing to accelerate wealth can be a very successful investment strategy. It’s just important for people to remember to keep bad debt to a minimum and make sure they use good debt wisely — otherwise, it can all turn a little ugly.

Please note: This article contains general information only. It is not advice that therefore should be acted on. You need to consider with your financial planner (if applicable), your investment objectives, financial situation and your particular needs prior to making any strategy or product decisions.

Author: Josh Wilson, Monarch Institute