Debt. In a time where the Reserve Bank cash rate and similarly the interest rates for borrowing are the lowest we have seen, it has become a temptation for us as consumers to borrow.

So, what exactly is debt? Debt is the obligation for one party (debtor) to pay money to another (creditor). We almost all certainly have had a debt, and it remains one of the most common financial goals of clients to repay debt and be debt-free.

A case can easily be made that there is no such thing as good debt and that to owe money is always bad, but this does not have to be true.

Let’s break debt up into 3 areas. Good, bad and smart

Good

Often when it comes to a big-ticket item, debt may be the only option as a means of raising funds to purchase the good. The main item here is your home. A home can be seen as a key item that can be funded through rent or home ownership. The idea of rent being ‘dead money’ which could be used towards a home purchase through debt repayment, leads many consumers to the decision to borrow for their own home, and why not when the government also provides incentives for first home buyers. Another benefit is that under most circumstances, the primary residence is also capital gains exempt.

Knowledge is a powerful resource and with it can often come greater opportunity to build wealth through employment. Borrowing for study can be very beneficial to help get that new job or to ask for a pay rise. Care must be taken to ensure, when selecting a course of study, that the future benefit will be there. The Higher Education Loan Program (HELP) is a government support loan that may help fund further education.

The last item I will cover as ‘good debt’ is one to borrow for a small business. Being your own boss, earning a salary and controlling your employment are all very positive features. There is a greater risk with this loan given the history of failures of small businesses. Much of the business success will depend on your willingness to work hard to build and maintain the business, determining from the outset that the business will be profitable and be able to repay the debt, and gaining an understanding of the type of business and how to manage a business prior to commencing.

Bad

‘Bad debt’ involves the borrowing of money to purchase a depreciating asset often through a personal loan. We all know this one and are guilty of discretionary spending on items in this category. Loans of this type are typically at higher interest rates, only increasing the reason for defining them as ‘bad’.

Our most common item for ‘bad debt’ is the family car. It is often seen as a ‘good debt’ for the reason of the functionality it provides, but the reality is that in most cases, the value of a car depreciates (in cases of new cars by up to ~$5000 upon leaving the showroom). By the time of debt repayment, the vehicle is often worth less than 50% of the value initially paid. Boats, motorbikes and jet skis are all similar examples of ‘bad debt’ loans.

Credit card and ‘Buy Now Pay Later’ debt is by far the biggest issue of ‘bad debt’ for most Australian households. Our penchant for spending on consumables, goods and services ensure that many of us require these credit options. Whilst an increase in the use of debit cards (spending money you already have) has reduced credit card use; through COVID-19, with reductions on the use of cash and an increase in online purchases, we have seen this type of debt continue to increase. For more information on credit cards, refer to the article in The Investment Collective’s Winter 2020 Newsletter by Cheng Qian. Our ever-increasing desire for discretionary spending on clothing, music, holidays, take away meals and even that morning coffee can all contribute to bad debt.

Smart

The last category is smart debt. Often referred to as an investment debt or gearing. This debt involves borrowing money (at a low rate) to invest in a product that will hopefully have a higher rate of return to generate wealth in a faster manner. There is an obvious risk with this debt and that is the need to generate a return with a higher rate than that being paid, otherwise, there is financial loss. That is, whilst it can magnify a gain, it can also magnify a loss. This type of borrowing can provide an income tax deduction and enable a larger portfolio to provide greater diversification in your portfolio to reduce risk. Gearing should only be considered after discussions with your financial adviser to see if it is a suitable option for you and your financial circumstances and goals.

In summary, commencing debt can be very tempting and even seen as a need, and at the right time and for the right reason, can easily be a justified option rather than saving the amount in full prior to purchase. Debt will always need to be repaid and when looking at commencing a significant debt, always take the time to discuss the situation with your financial adviser to see how it fits with your financial situation, goals and objectives. A well-managed approach to debt can ensure that no matter what category of debt (good, bad or smart) that it delivers for you.

Please note this article provides general advice only and has not taken your personal, business or financial circumstances into consideration. If you would like more tailored advice, please contact us today.