DISCLAIMER: This chapter references general topics like deductible debt, but nothing included should be interpreted as tax advice. You should see a tax adviser if considering these topics.
Consumer debt is a common trap, and a stealthy destroyer of personal wealth.
But debt can be necessary, and even used as a powerful tool for reaching financial independence.
There is a scale from terrible (life-destroying) debt to “Good debt” used efficiently to build wealth.
In this chapter, we'll get into the nitty-gritty details about the different types of debt & general debt considerations. Specifically:
- What is Bad Debt?
- What is Tolerable Debt?
- What is Good Debt?
- When Good Debt Turns Bad
- Advanced Debt Utilisation
What is Bad Debt?
Many individuals are stuck in a bad debt cycle, often through extremely difficult circumstances.
If income is less than your expenses and you are forced to borrow for essential needs such as groceries, the situation is dire. Even a small deficit (say $10/month), will accrue debt, which becomes much harder to pay off over time. Add interest and late fees and this soon becomes a nightmare downward spiral.
Others, not through necessity, but a lack of understanding, choose to enter the bad debt cycle.
Consumer debt is what is generally meant by “Bad debt”. It is debt used to buy goods that are consumed or assets that will not grow in value. Classic examples include car loans, credit card “shopping therapy” and borrowing to buy a boat.
Paying interest on debt that is not essential, to buy assets that lose value once purchased is a little insane. But people do it all the time. “I deserve it” and “I can afford the repayments” are common justifications.
“It’s time to share a big chunk of my future wealth with a bank/credit card company!” Admitted no-one, ever.
It’s easy to miss the significance of accumulating consumer debt when the repayments are affordable and the purchase desirable.
But just as in a poverty induced debt spiral, the debt becomes harder to repay over time.
All income levels are susceptible to this, including high-income earners, who tend to borrow bigger and brasher. The repayments may be manageable, but they are stealing your opportunity to build wealth.
You may have heard of the “Debt snowball” and “debt stacking” (see Chapter 2), which encouragingly make debt pay off sound easy.
But there is a long period before the snowball or avalanche begin, where you’re trying to make a dent in your debt.
Most of your cash is going to interest until you can start making a significant impact on the principal. I call this the “Debt Dung Ball”. It always takes far too long to pay off debt!
If you’re ever thinking of going down this road, take a quick look at MoneySmart’s Credit Card Repayment Calculator to make sure you’re going into the decision with eyes wide open (screenshot below).
Car loans
A car purchase commits you to many additional expenses including registration, insurance, fuel, and maintenance. If you need a car, it is wise to limit the damage as much as possible.
As soon as you purchase a vehicle, it is losing value over time (depreciating). New cars depreciate quickest in the first five years, making second-hand cars better value generally.
Borrowing to buy a car adds interest to the cost of the car, boosting the negative effect on your long-term wealth.
People often borrow from their mortgages to buy a new car, due to the low-interest rates incurred. At record low interest rates of 3%, a modest $30,000 car paid off over 5 years will cost an extra $13,125 in interest.
If you pay the debt off over 15 years instead of 5, it will cost you another $30,711 in interest (even at 3%) – doubling the cost of your car!
But yes, if you have to borrow to buy a car, and your repayment behaviour will remain unchanged, then it makes sense to use the mortgage. Really try not to though.
Personal loans, credit cards and buy now, pay later.
Personal loans currently charge around 6-8%. They are often used for boats, cars, holidays and general living-beyond-means expenses. The value of all these purchases decrease over time, and the interest rate is significant.
The widening gap between asset value (decreasing over time) and total cost paid (increasing over time) is the exact opposite of what you want to achieve in order to build wealth.
If you want to be dirt poor, one of the fastest ways to do it is by letting credit card companies scalp you 12-30% interest on depreciating goods. Brutal!
Buy now, pay later schemes are similar to a credit card with an interest-free period. Potentially free if paid off without fail, but quickly punished with fees if repayments are late. They tend to be used for retail purchases, which fall in value after purchase.
These are all methods to spend more than you earn, and slowly degrade your future wealth.
What is Tolerable Debt?
Tolerable debt is often debt that you cannot avoid. In the original example, the first $10 debt to buy groceries may be tolerable to allow time for extra income to be earned to make up the deficit.
A car loan may be tolerable debt if there is no other way to get to work to earn an income (no available public transport). In these cases, the bare minimum debt should be incurred, at the lowest interest rate. Pay the debt off as fast as humanly possible to get back on track.
Home loans, in some cases, are tolerable debts too. If the home is not an investment you would purchase for its growth potential, it is a tolerable rather than good debt.
Many towns have average or worse capital growth expectations for property. It makes a lot of sense to keep your home mortgage modest in these circumstances and leave borrowing power for better quality investment assets.
What is Good Debt?
Good debts are those used to buy assets that grow in value (appreciate) over time. The intention of taking on these debts is to increase the net wealth of the borrower, despite interest paid.
For a debt to be classed as “Good” the asset MUST have an expected after-tax return greater than the interest paid. Good debt loans usually charge the lower end of interest rates available at the time.
Taking on good debt involves risk, and can sometimes go badly.
To make an informed decision taking on a “Good debt” it’s important to understand all the potential risks, as well as your risk tolerance.
Borrowing to Buy Property
Borrowing to buy a carefully chosen home or investment property can be considered good debt. This can be a powerful way to build wealth.
But expected and actual after-tax returns must be greater than interest owed to make a debt productive. It is not enough to buy any asset (including property) and expect it to perform well.
In 2010, Amy incurred $400,000 “Good debt” to buy an investment property. Amy had friends who had made a significant profit in Darwin properties. She brought a 4 bedroom home on plenty of land.
A decade later, the house is now worth $325,000. The bank doesn’t care she hasn’t made a profit, as Amy has to pay the interest regardless of the property’s performance.
To make matters worse, in order to free herself of the underperforming property, Amy will need to find $75,000 to pay out the remainder of the loan after sale.
Amy is not alone. Many investors have investment properties worth far less than they owe, with their borrowing capacity tied up in an asset too expensive to sell.
Borrowing to Buy Shares
Other investment loans, for example borrowing to buy shares, are also traditionally considered good debts.
The long term returns for the ASX since 1900 is an incredible 11.8% per annum.
Borrowing at 3% to buy and hold shares over the long term would be a productive debt, as long as returns were greater than the interest paid. This, of course, is never guaranteed.
Student Loans
Borrowing money to study is generally considered a good debt. The qualification should be to work in a field you will enjoy long-term. If you will be able to secure work after graduation, and the income over the long-term will compensate for the time and money spent studying, student loans can be a very effective use of debt.
Taking on student debt and failing to complete your qualification is a regrettable waste of money and time. Debt is not forgiven if you drop out or change courses multiple times.
If there is little employment in the field your studies qualify you for, high levels of competition or poor pay, the financial burden taken on may not be worthwhile.
This is a huge decision to make at 18 or so! If in doubt, consider a year of work experience to give you time and insight.
Home Renovations
Borrowing to improve your home can be a good debt, but rarely is.
The resulting value of the renovated property should compensate for the amount paid for the renovation including interest. It is very easy to overcapitalise on your home by improving it beyond the top price point of the suburb and street.
This then becomes a lifestyle choice – best not funded with bad debt. If you are keen to improve your home, assess what the realistic best post renovation valuation is and use this to guide your budget. If you are investing for lifestyle, consider saving and paying with cash to minimise the negative financial impact.
Small business
Small business debt can be a very powerful use of debt – business is a rapid wealth builder if successful.
But it is very high risk; according to the Australian Bureau of Statistics, more than 60% of small businesses fail within 3 years. Debt taken on to fund a small business that fails is obviously a bad debt.
A small business idea should be thoroughly thought out, researched and planned with realistic risk management before any debt is taken on.
Debt for Cashflow
“Cashflow is king” is a common catchphrase among investors. Everyone needs adequate cash flow to get them through rough times.
When taking on your biggest debt, a mortgage, consider borrowing a little extra to stock an emergency fund. Owners are usually most vulnerable in the first year or two of a mortgage (home or investment).
Stashing any extra borrowed along with ongoing savings in a 100% offset account is ideal. You will not pay interest on the money whilst it’s in your offset account. As long as you don’t raid it for non-emergency spending, you will pay no more interest for the added flexibility.
Debt for Tax Optimisation
Paying off the home mortgage is a psychologically tempting prize. Flexibility here should be considered, in case of job loss or other unanticipated disasters.
Placing extra funds into an offset account, rather than a redraw facility, means you can withdraw your money without the bank’s consent. If circumstances change, banks can stop you redrawing money, but cannot stop you accessing offset savings.
Circumstances often change more than anticipated, and the home you planned to live in forever may eventually become the perfect rental property if you move.
If you have paid off the mortgage, you cannot then redraw and make interest tax-deductible. If you have only offset the mortgage, you can move your cash and deduct interest paid against rental income.
When Good Debt Turns Bad
Bad Timing
Whatever asset class you invest in, no-one is able to tell you what the returns will be in ten years.
Borrowing to invest at a bad time can result in several years of negative growth.
This tends to happen when an asset class has done particularly well over the preceding years. It is constantly in the news, everyone is talking about it, and those not already invested feel they are missing out!
An unpredictable amount of time later, the peak of the market declares itself when the asset price collapses, devastating to those leveraged into the investment.
If you borrow to invest, you must be able to manage this risk. Resist the temptation to follow the crowd, and be suspicious anytime there is excitement over a particular investment class.
Only invest for the long-term. If a reasonable investment is held long enough, it is likely to recover and benefit from another period of growth. If sold, you crystallise the loss and pay interest for the pleasure.
Default risk
Good debt can turn bad quickly in the event of being unable to service the debt.
Underestimating holding costs of property, failing to anticipate future increases in expenses or drops in income can cause loan defaults, or selling at the wrong time. Before taking on good debt, carefully identify and minimise all risks.
Opportunity Cost
Even when you have a “Good debt,” there may be better opportunities for it.
Buying your own home would generally be considered a good or tolerable debt. Perhaps the expected capital growth for that home is a little over the interest paid at 4%. Depending on your risk profile, future plans and preferences, there may be a more efficient use of that borrowing power (see Chapters 19 & 20).
Every time you decide to take on debt, it is worth considering whether there is a better use for that debt. Everyone has limited borrowing power, use it effectively!
Advanced Debt Utilisation
Credit Score and rewards
Credit scores are how lending institutions assess your reliability to pay back debt.
Having a good credit score makes it easier to get a loan, may increase the amount you can borrow, and lower the interest rate.
It is not impossible to get a loan without a credit history, but it may be harder.
If you have utility bills, a mobile phone plan or any other history of borrowing you will have a credit score.
You can obtain a free copy of your credit score from Equifax annually, and monitor it month to month at Creditsavvy.com.au. This is important to monitor for mistakes on your file, and the effects of credit card applications (especially for travel hackers).
Credit cards can be a tool to build a better credit rating over 12 months or more, for those wanting to secure a mortgage at a great rate.
It is a lot easier to spend excessively with plastic than cash. Do not get a credit card if you’re not sure you can control your spending and pay the full balance every month without fail.
If you feel you can handle credit cards, consider finding one with no annual fee. You need to outplay the credit card company. They want you to spend on your card, fail to pay it off completely and start paying them ever-increasing interest. Organise the full balance to be paid off each month automatically through the credit company. Make sure you will never pay them a dollar in interest or late fees through missed repayments.
Debt to income ratio
How much debt should you take on?
Any debt is unproductive if you are unable to consistently make repayments without putting stress on your household.
A common rule of thumb is that home mortgage repayments should be less than 30% of your take-home pay. If you maximise this, you are using most of your borrowing power, limiting opportunities for leveraging into investments.
There is no acceptable limit for bad debts – they are devastating your finances so should be eliminated ASAP.
Total debt repayments including “Good debt” should only be pushed higher than 30% if you have assessed expenses, risks, future changes to income and expenses and have a generous emergency fund saved.
About Aussie Doc Freedom | Aussiedocfreedom.com
I’ve spent much of my life with my nose in a book – either studying medicine, or learning about finance! I discovered and enthusiastically embraced the financial independence framework as a structure for my tangled ideas around values-based spending, freedom and choice. I am pursuing FI, planning to perform part-time work that I love, and leaving plenty of time to spend enjoying my beautiful boys.
NOTE: Aussie FIRE is a free educational resource prepared by Pearler, with permission from the co-authors. At Pearler, we strive to make investing for your long term goals easier and fun, but we only provide general information and/or general advice. We don’t present you any options based on your personal objectives, circumstances, or financial needs. Any advice is of a general nature only. All investments carry risk. Before making any investment decision, please consider if it’s right for you and seek appropriate taxation and legal advice. Please view our Financial Services Guide before deciding to use or invest on Pearler.
