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Good debt v bad debt

Debt doesn’t have to be a dirty word, especially if it’s funding your future, writes Sally Patten.

It’s official. Australian households are the most indebted among rich countries.

Research from LF Economics, using official data, shows that Australian household debt has risen to 123 per cent of the nation’s economic output, pushing Denmark and Switzerland into second and third place respectively.

Furthermore, the household debt-to-income ratio reached a record 186 per cent in 2015, according to the Reserve Bank.

The rising level of indebtedness has been partly blamed on the housing boom, which has forced many home buyers to take on bigger mortgages simply to put a roof over their heads, or make a property investment.

The headlines may sound scary, but it is not necessarily all bad news.

As Alex Berlee of AMP Financial Services points out, debt doesn’t have to be a dirty word. It might sound weird, but there is such a thing as good debt and bad debt.

“The right kind of debt can be helpful. Good debt can create wealth and bad debt reduces it,” says Berlee.

Debt is generally considered to be positive if it helps you buy assets that have the potential to increase in value and provide an income. This could include your home loan. You might also be able to use good debt to reduce your taxable income, but seek independent advice on how this would play out for you and remember that properties can go down in price as well as up.

What is good and bad debt?

Another example of good or positive debt may be borrowing money to purchase an investment property. Over time, the price of the property may rise by more than inflation. You may also receive an income in the form of rent from tenants.

Furthermore, interest expenses can generally be claimed against your taxable income, potentially reducing your overall tax bill.

However, you should always remember that investment assets may go down in value as well as go up, or you may have times where a rental property may sit empty and not provide an adequate income. It is important to seek appropriate advice and consider your personal circumstances, and how you may deal with times of a negative investment return, prior to entering into a gearing strategy.

Bad debt is generally considered to be borrowings you take on to buy goods that will depreciate in value, won’t help you to earn any money and are not tax deductible.

Using your credit card or a personal loan to go on a holiday or buy a fancy car may not be an effective use of debt.

The former isn’t worth anything (at least financially). Sure, the latter might make getting to work easier, but a Toyota Yaris will get you there just as well as an Audi A3 Cabriolet. Borrowing big to buy a new car is rarely going to do your financial health any favours.

If you are trying to win the war against debt, you should generally pay off non-deductible debt first, such as credit cards and personal loans, which often have higher interest rates.

One option, depending on your financial needs and personal circumstances, may be to transfer debt from credit cards and personal loans onto your home loan, where the interest rate will generally be lower. The trick, though, is that you will need to be disciplined enough to increase your monthly mortgage payments commensurately, so you are not adding to the size of your home loan overall.

Borrowings against investments, such as investment property or shares, should generally be paid off last because the interest payments can be claimed against tax.

Student debt is the ultimate

Starting adult life with a large debt is not ideal, but gaining a tertiary qualification makes it worthwhile, according to Michelle Kulik.

Like many university students, the 19-year-old has taken on a government HECS-HELP loan to enable her to study. She estimates she will have a $36,000 debt upon graduation.

“Overall, to get an education, then to go on to [hopefully] get full-time work, the debt is something to benefit my future,” says Kulik. “When you do well in your job and are successful, you pay back the debt.” After completing a media and communication diploma last year, Kulik started a journalism degree at Deakin University's Melbourne campus in March with the aim of working in broadcasting or secondary education.

Kulik lives at home, studies Auslan as a side interest and runs a car “one month younger than I am” with money earned from casual work at a clothing retailer.

Most of Kulik’s peers have HECS debts.

“I’ve got friends who’ve completed uni who say it’s the best feeling when they’ve paid it down – the lower the debt, the prouder they feel,” she says.

“It’s the first massive adult commitment and to pay it off gives a great sense of accomplishment, especially if you’re paying it back with a job you’ve got through uni.”

But the HECS debt does already weigh on her at times.

“When you think about it, when you get a full-time job you’ve got to immediately start paying it back [provided you are earning over the threshold] at the same time you’re buying a house and starting a family and all the other stuff that comes after uni.

“But there’s a good feeling that there’s something at the end of it. And [for me] it’s better than paying upfront.”

Case study: Natasha Hughes

October 2016