Good debt vs bad debt

By Cutcher & Neale Accounting and Financial Services - February 10, 2021

It is common to have an uneasy feeling at the thought of debt. We have all heard the cautionary tales of unmanageable maxed out credit cards and personal loans. Though for most, especially those who own their own home or have pursued higher education, debt is a normal part of life.

So, with debt so present in our everyday lives then it is important that we understand when debt is an opportunity for growth and when it should be avoided.

Debt can be a great tool that provides long term benefits, both for individuals and businesses, when it is used for the right things and structured in an efficient way.

To assist you in navigating the world of debt we have identified 3 key principles to consider when you are thinking of taking on debt:

Principal 1: What am I using it for?

Arguably the most important principal, considering whether the debt is to fund an investment that will provide you with benefits over time is critical to the idea of good vs bad debt.

An investment can come in many different forms; it could be purchasing a property to enter the property market, new equipment that allows your business to take the next step or taking on further education to increase your personal earning potential in the future.

The types of debt to be wary of are those that fund purchases that reduce in value over time. Loans to purchase new cars, credit cards that can’t be repaid on time and personal loans for holidays and retail purchases are all examples of purchases that reduce in value while the costs increase as interest is charged on your debt.

Principal 2: Am I limiting my interest?

Interest is an unavoidable cost of taking on debt, but while you can’t avoid it completely you can ensure that it is limited and where possible tax effective.

Certain types of debt will generally result in lower interest rates, loans for property will generally have a much lower interest rate than those for credit cards and payday loans. Generally the ‘riskier’ the loan to the lender, the higher the interest rate will be, so if you are able to utilise your equity in an existing asset or draw down on a mortgage then it can result in a better outcome then to take on these debt types that are ‘riskier’ for the lenders.

Principal 3: Is this tax effective debt?

The other consideration for interest is whether it is tax deductible. Where your debt is for an income generating investment such as a rental property, share purchases or business loan the interest can be a deductible expense against this income. In the case of a rental property, where the property makes a loss overall (negatively geared) this can even offset your other income, reducing your overall tax bill.

The interest on debt that is used for personal purchases such as your home will often not be tax deductible. Therefore, when you are considering making a personal purchase and an investment you should utilise the cash you have to limit the personal debt that is not tax effective so that more of your overall interest costs are for your investment which is tax deductible.

This principal also applies to when you are reducing your debt levels. If you have capacity for additional repayments, then focus on repaying the debt that is not tax deductible over the debt that is.

Any time you are thinking of taking on large amounts of debt it can be a difficult decision and one that you want to ensure you are doing correctly.

If you would like to discuss your debt situation then please get in contact with your Cutcher & Neale Advisor.

The team at Cutcher & Neale are here to help, please get in touch if you would like further assistance.

 

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