I’m one of those people who hates owing money. If a friend picks up the bill after dinner, I make sure I transfer my portion ASAP. But, I’ve come to learn that debt is pretty much unavoidable and not all debt is the end of the world.
There are two kinds of debt; good debt and bad debt. As much as we should try to avoid bad debt, sometimes life gives us no other option. The best thing you can do is pay off your debt as soon as you can.
So, what is good debt? Good debt is a loan that has the potential to improve you financial position and increase your net worth. Your net worth is the value of all your assets minus any outstanding debt.
Bad debt is borrowing money to purchase depreciating assets. The best example of a depreciating asset is a new car. The second you drive it out of the dealership, it starts losing value.
There are some blurred lines between good and bad debt. Whether a debt is good or bad can depend on an individual’s financial circumstances and a range of other factors. The following examples are general examples and may not apply to every single person but let’s go through them.
4 examples of good debt
1. A student Loan (HECS/HELP)
Education is an investment in your future. A degree greatly increases your chance of earning more money versus if you receive no formal qualifications. On average, a female with a bachelor’s degree earns $13,963 p.a. more than a female with Year 12 qualifications only. A HECS/HELP loan has some of the best repayment terms out there. You don’t pay any interest, instead indexation is applied to your debt to maintain its real value by adjusting it in line with changes in the cost of living. This year (June 2020) indexation was 1.8%. You won’t have to start paying off your loan until you reach the compulsory repayment threshold. The threshold for the 2020-21 income year is $46,620 and the threshold for the previous income year of 2019-20 was $45,881. Once you hit the threshold, your employer will pay a certain percentage of your income towards the loan.
2. A home loan
For many people, owning their own home is major goal (albeit not an easy one). Acquiring a home loan is good debt, as over time your property (whether it be the home you live in or an investment) should increase in value. You can use this increased value to upgrade to a bigger home or a better location. Or you can sell your property and downsize to a smaller place later in life and use the profit for your retirement. As with all debt (good or bad) it’s smart to pay it off as quickly as you can if you can afford to. When interest rates are low (as they are now) it’s a good time to make extra repayments towards your loan.
There is an exception: when you apply for a loan, the bank or mortgage broker will give you a number that you can borrow up to. You don’t have to borrow the entire amount. If you decide to borrow up to maximum limit, you could find yourself with a loan that’s too expensive for your lifestyle and you may suffer financial stress. A general rule of thumb is your mortgage repayments should be no more than a third of your take home income.
3. A business loan
Borrowing to start or grow your business is good debt as businesses should create profit and increase your net worth. Common reasons for borrowing money for your business include managing your cash flow, funding your growth or buying a vehicle or equipment for your business. As with a home loan, you should work out how much you need to borrow and calculate what you can afford to repay. Don’t overstretch yourself.
There is an exception, which is borrowing money to fund a loss-making business.
4. Borrowing to invest
Borrowing to invest is a medium to long-term strategy (at least five to 10 years). It's a high-risk strategy that should only be for experienced investors. It's typically done through margin loans for shares or investment property loans. The investment is usually the security for the loan. If you’re borrowing to buy shares, the bank will have an approved list of shares, and blue-chip stocks would be preferred. You have to prove that you can service or pay back the loan.
It's very important to know that higher risk strategies mean you could make a lot of money or you could end up with a big loss. Be careful with margin loans and make sure you totally understand what you’re getting yourself into. This kind of borrowing comes with risk. We’ll be writing more about this at Tilly Money, so watch this space.
3 examples of bad debt
1. Car loan
Cars depreciate the moment you drive out of the dealership. You will be paying interest on a depreciating asset. Taking out a car loan to have a nicer car than you can afford is not a smart money move. It is better to pay cash for a reliable used car, the best you can afford, but make sure you factor in servicing, registration, petrol and insurance.
As always there are exceptions like is you use your car to earn a living driving for a ride sharing or food delivery app. Sometimes a car loan is necessary if you can’t afford to buy outright but need a car to travel for work. If you use your car for business or work, you may be able to claim a tax deduction.
2. Credit cards
The interest rates charged on credit cards are often significantly higher than the rates on consumer loans. To avoid accumulating debt on a credit card, only use the card as a means of transacting and pay the balance in full every month.
The exception: if you don’t live beyond your means and pay off your balance every month, a credit card with a good rewards programme may be worth your while. When you spend, you gain points that can be redeemed on air tickets, cruises, cashback and many other rewards.
3. Borrowing for a holiday
Taking out a loan or using your credit card to book a holiday is definitely bad debt. Travel is an enriching experience and who doesn’t love a holiday? But you don’t want to end up in a pile of debt over a month in Europe. Big holidays, like the ever-desirable European trip, are something that you should set as a savings goal. You may need to make sacrifices to reach your goal, but it will be worth is in the end. You will be able to enjoy your trip much more if you can pay for everything up front and not come home to a negative credit card balance.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.
Head to Tilly Money for more stories on financial literacy. Or read more from Tilly Money here like how to start buying shares.
