Interest rates are rising and we have just been through the GFC caused mainly by a debt fueled spending binge. The focus is now certainly on debt of all levels, personal, business and government.
While most of us want to be debt free, the fact is, in some cases it makes good sense to have some debt and it can actually help to grow your wealth. It comes down to categorizing your debt as ‘good’ or ‘bad’.
The main differences between good and bad debt are tax-effectiveness and return on investment. If you use debt to buy items that don’t appreciate or at least hold their value, this is ‘bad’ debt. For example, credit card debt is likely to be made up of consumer items that depreciate in value.
Of course the primary ‘bad’ debt that most of us hold is the mortgage on our own home. The only sure-fire way to save money on your mortgage is by having a lower interest rate (as long as the fees don’t go up to compensate) or to increase your payments.
It’s really worth spending the time to find if there’s a better mortgage out there, either with a lower interest rate or with terms that suit you better.
What seems like a small difference in interest rates could mean saving tens of thousands in the long run. Of course given the current RBA trend it is important to factor in higher interest rates
Good debt is…
Any debt that works to make you more money than it costs you is classed as ‘good’ debt. This of course includes borrowing to buy investment assets such as a business, shares or property.
However, your higher potential return comes with a higher risk. Should the investment fail or fall in value you’ll not only lose your cash, you’ll also have to pay back what you borrowed, so it’s not a strategy for the faint-hearted or those less disciplined with their cash.
Turning bad into good
If you have a loan linked to an investment property, or if you moved to a larger property and kept your current home as an investment property, this can make your loan very tax effective.
Making additional mortgage repayments is a safe and sensible strategy because it represents a tax-free, risk-free return. Plus most of us have grown up hearing our parents say that the mortgage comes first, and in many cases it makes sense to prioritise paying off your mortgage.
You could also use the equity you have created in your home as security for tax-effective borrowing for investment to grow your wealth – so turning your ‘bad’ personal loan debt into ‘good’ wealth generating debt.
A disciplined approach of releasing cash flow to gradually transform bad debt into good can help create lasting wealth. By investing some of your funds in assets such as shares, property, or assets which are likely to appreciate in value, you can grow your surplus income to optimise your wealth.
What’s stopping us?
Bear in mind that no amount of deductions will make up for a poor investment return, so gearing shouldn’t be used as a tax reduction strategy.
Before taking the plunge ask these questions:
- Is this the most cost-effective way to borrow what you need?
- How long will it take you to save the money?
- Calculate how much interest you’ll end up paying – is it really worth it?
- Be honest with yourself about how disciplined a borrower you are.
Many of us have been brought up to think instinctively that debt is bad and must be paid off as soon as possible; so using debt to create wealth goes against the grain. But if you’re managing your cash flow and have a clear plan, borrowing to invest can be financially rewarding.
Sean Ryan
Partner, TFS Financial Planning
