Good and Bad Debts
Is there such as thing as good and bad debts?
How would you feel in this position – half way down a cliff face, with no knowledge or experience on how to take the next step? In this blog, which is part of our series on ‘why managing cash flow doesn’t need to be an extreme sport’, we take a look at good and bad debt.
It’s a common thought that we need to avoid debt or pay off any debt we have as fast as possible. That is good, solid, but conservative advice. Why conservative? Because you may be able to grow your financial assets faster by using what we call good debt. Let’s explain this:
From a financial planning perspective, you would like to have no debt, but if you do have debt, you really want to ensure that the interest you pay is tax deductible. Tax deductible interest (interest on loans for shares, rental properties, and other income producing assets) is good debt. Interest that you pay on your home loan or personal credit cards or on personal loans is bad debt, because you cannot claim this interest as a tax deduction.
Most people have a home loan and personal credit cards, and the interest on credit cards is much higher than for your home mortgage. That’s why financial planners recommend that you use whatever surplus income you have each week to first pay off your credit cards, and then once you have done this you can start to make extra repayments towards your home loan. If your home loan has an interest rate of 6%, then you effectively earn 6% for every dollar you pay off your home loan.
Here’s where debt may be good for you
If you feel comfortable investing in shares and you expect a 10% return for the year, you could withdraw an amount from your home loan (if you have a redraw facility) and invest this in shares. Your share investment may make a 10% return for the year (dividends received and capital growth), your interest cost is 6%, and this leaves you with a 4% gain for the year. So, if you invested $100,000 this way, you would make an extra $4,000 per year after interest costs. Sounds good, doesn’t it?
There are always risks with any investment and please don’t take this article as advice to invest – this is something that you need to talk to one of our qualified financial planners about. The point is to educate you about the opportunities that you should at least consider to grow your wealth.
Very Important: You need the right type of loan
For years we’ve all seen the TV ads recommending equity loans – loans that we can redraw against if we need access to funds. If you want to invest, unless you’ve fully paid off your house an equity loan is the WRONG loan to use.
You need to use a Split Loan – a loan that has an overall facility limit but is broken up into two different portions, each with their own monthly statement. The first split is usually for non-tax deductible debt like your home loan and funds redrawn for private use (eg. if you use some funds for a holiday).
The second split is for investing. All of the interest for this second split is tax deductible. If you want to repay any debt with surplus income, you can simply make payments against the first split and reducing the balance, but at the same time seeing you are not paying off any tax deductible debt from the second split, you keep higher tax deductions for interest from the second split.
We can help you!
We specialise in loan structuring to ensure your wealth is maximised and your tax is minimised. So, get in touch for a home loan review and, maybe, some good debt will make a big difference for your future. We’ll help you get a handle on your cash flow (in and out), so managing it doesn’t seem like an extreme sport.