Not all debt is created equal, although it can sometimes be difficult to interpret what is meant by the terms good debt and bad debt. Surely $1 owed is $1 owed right? Well not quite.
How do we interpret what is good and what is bad when it comes to debt? A simple rule is this: if it increases your net worth or has future value, it’s considered to be good debt. If it doesn’t, then it’s bad debt.
Debt can be used to leverage your financial position to purchase assets or make investments. The idea is that these assets go on to appreciate or grow in value beyond the rate you could achieve through things like a savings account. Debt can also be used to go on a holiday or buy a new car. These are not going to appreciate in value and on top of it, you are paying extra interest, therefore whatever you’ve bought on credit is costing you more than it was ever worth in the first place.
In Australia, we have an average debt-to-income ratio of 195%. This means if you earn $100,000 per year, you have debt of $195,000. There are all sorts of different ways you can calculate your debt to income ratio such as looking at your monthly income versus your monthly debt or your annual income versus your overall debt position.
For example, if you earn $3,500 per month and pay $1,800 on your mortgage and $200 on your credit card it looks like this:
$2,000 / $3,500 = 0.57 x 100 = 57.14%
This is considered relatively high because over half of your monthly income is going toward paying debt. Many financial experts believe no more than 30% of your income should be going toward debts – good or bad.
What is good debt?
Good debt can be things like a home loan because you’ve purchased an appreciating asset, student loans because you are investing in your education to improve your career prospects and earning potential, asset loans (provided the interest rate is reasonable) and investment loans.
For people purchasing property as an investment, there are all sorts of deductions that can be claimed back at end of financial year through the ATO. For a full list download our Entourage Report 2020 here.
Some people borrow money to invest in shares, this can be a good option but your investment returns need to be higher than the interest you’re paying on the loan. Borrowing for investing can include investing in a business too, not just publicly listed on the ASX. If you’re investing in a profitable business that has a good rate of return, then again this can be seen as good debt. Sort of like spending $1 to make $1.50. In any instance of borrowing to invest, for it to be good debt, the return needs to exceed the interest paid on the loan. It must be data driven and methodically calculated to ensure it makes financial sense.
What is bad debt?
It’s going to come as no surprise that the following are considered bad debt:
- Credit cards
- High interest loans
- Car loans (particularly for brand new cars)
- Payday loans
- Personal loans
Interest rates range anywhere from 10%-25% and beyond for credit cards, personal and high interest loans and payday loans.
Credit cards and payday loans are the worst kind of bad debt. They have very high interest attached to them and if you’re only paying the minimum repayment, can create a cycle of debt that is close to impossible to get out of. These types of debt are very expensive and often reinforce the concept of spending money before you’ve earned it or in some cases, just flat out spending money you will never have.
Instead of reverting to credit, Entourage Wealth Financial Planner Andrew Edwards recommends saving. “If you want to go on a holiday with your family or renovate the kitchen then start saving. Choosing to pay for a $5,000 holiday on your credit card means you’re actually spending $6,000 when you calculate the 20% interest that you’ll end up having to pay.”
Can good debt ever be bad? Can bad debt ever be good?
Yes, and yes. Good debt turns into bad debt when there’s too much of it. If you can’t meet the repayments on your home loan or student loan, then it’s bad debt. Many Financial Planners recommend no more than 30% of your income going towards your home loan (or rent).
If you’re upgrading your car every few years and constantly financing it, then that can also be bad debt or really, just wasted money. You’re better to save up and contribute as big a deposit as possible when buying a car so you’re not paying far more in repayments than the car was ever worth in the first place.
Sometimes what is bad debt for a consumer can end up being good debt for a business or investor once tax deductibility comes into play. Using our car example from above, if the car is being purchased through a business there are certain deductions and depreciation that can be claimed which may make this worthwhile.
This article contains general information only. It should not be relied on as finance or tax advice. You should obtain specific, independent professional advice from a registered tax agent or financial adviser in relation to your particular circumstances and issues.