06 Feb Good Debt vs. Bad Debt: What’s the Difference?
One thing that keeps most people up at night is debt. Australian household debt has risen over the past 30 years as more people rely on car loans and credit cards. In Australia, the ratio of debt to income has more than doubled between 1995 and 2018, from 104% to 216%1. This means that a person earning $95,000, is spending $205,200 per year.
Since the 2008 global financial crisis, Australia’s debt levels have increased while many other developed countries have declined or plateaued in debt levels. As a result, Australia now has some of the highest personal debt levels in the world.
Good Debt, Bad Debt: An Overview
In many ways, all debt is the same. An argument can be made that all debt is bad. However, debts can have positive or negative consequences. For instance, getting a loan and taking on debt is the only way many people can afford large purchases like cars and homes. While these loans are often justifiable and bring value to an individual taking on the debt, there is another end of the spectrum that involves accruing debt through careless spending.
What is Good Debt?
An explanation of good debt can be summarised in the term “spend money to make money.” If the debt you take on allows you to generate income and build wealth, it can be considered positive. Good debt allows you to better manage your finances, leverage your wealth and buy things you need and manage unforeseen emergencies. To summarise, good debt puts you in a better financial position in the long term.
Student loans allow you to get an education and increase your long term earning potential. On average, people with a bachelor’s degree earn 66% more in their lifetime than people without a degree6. People who attend TAFE or a similar trade school also significantly increase their earning potential while taking on a smaller amount of debt than those who attend university.
Both will likely pay for themselves in just a few years of entering the workforce as tertiary education has a positive correlation with the ability to find employment. Just as with any debt though, you must maximise its value. Choosing an education program that will lead to a well-paying career is important. If your chosen field has no career path or little income, it can quickly turn into bad debt. So while your friends may tell you to follow your dream of a career in the creative arts with a salary of around $40,000-$50,000, your financial advisor will probably tell you to pursue becoming an IT Network Architect with a salary of around $137,0002.
Small business loans
A small business loan can allow you to grow a profitable company to increase your long term cash flow. Making money is the main reasons to start a business while being your own boss comes in a close second. Your success is determined by your own willingness to work hard rather than relying on a third party to hire you and pay you. Small business loans are a lot tougher to get due to an increased risk to the lender. Many require you to provide a comprehensive business plan which forces potential business owners to consider goals and risks associated with starting a business. If you want to build serious wealth, your chances are much better if you start your own company.
Not all new businesses thrive though, as almost 30% of small businesses don’t survive their first two years3. Your chances of success will increase greatly if you choose a field you are passionate and knowledgeable in. With drive, ambition, hard work and a bit of luck, you can turn your idea into a self-sustaining enterprise.
Mortgages and Investment Property
There is probably no better debt to have than a mortgage. For one, you have a place to live. While it may sound simple, the strategic benefit of a mortgage is that your everyday living expenses build equity in an asset and you live somewhere that gains value each year. It also comes with built-in stability and security of owning your own home. From a wealth creation perspective, the most basic strategy involves buying a house, living in it for a couple of decades and selling for a profit. You could also rent it out and use that income to put back into the mortgage.
Over the last 25 years, Australia has seen an annual growth rate of 6.8% for houses and 5.9% for units, in dollar value terms, the median value of the typical Australian house has risen by $459,900 since 19935. The median home value on the Sunshine Coast hit $595,130 in June of 20184, $136,770 higher than the rest of Queensland.
Risks of Good Debt
When people take on good debt, they make assumptions about their future based on their goals and experience. Like everything in life, there are no guarantees. A degree doesn’t mean a job is waiting for you after graduation. Taking on more mortgage than you can manage or afford makes it difficult to save real money for the future. New businesses can fail.
Before you willfully take on any debt, carefully consider the return you can expect to get over time. What does life look like after taking on this debt? Where can things go wrong?
- Understand student loan repayments and when HECS and HELP payments start.
- Buy a home you can afford. Make sure your mortgage, rates and other expenses that come with owning a home don’t outweigh your income.
While these examples are considered good debt, too much of a good thing can be bad. Make sure you always consider how it will impact your life and how you can pay it off.
What is Bad Debt?
While good debt has the potential to increase your wealth, bad debt typically diminishes your wealth over time. Where good debt is generally borrowing money to purchase assets that appreciate over time, bad debt is borrowing money to purchase depreciating assets. Essentially, anything that won’t increase in value or generate income, you shouldn’t go into debt for it. This means that things like clothes, cars and TVs.
Credit cards are the pinnacle of bad debt. Credit cards have a well-earned reputation for ruining people’s financial health. Interest rates are the silent killer, often significantly higher than the rates on consumer loans, with payment schedules set up to maximise profits for credit card companies. If people knew how much they were actually paying to use a credit card, they would be much more selective in how they use them.
For example, you buy a TV for $1,200 with your credit card that has an 18.9% interest rate. If you make $60 repayments each month, it would take 63 months and end up costing $1,676.98. That’s $476.98 in interest that you could put towards your mortgage repayments or house deposit.
Car loans are generally considered to be bad debt because, unlike houses, cars don’t appreciate over time. Most of the time, as soon as you drive it off the lot, a car is worth half of what you just paid. But, on the other hand, Ubers and public transport are expensive, and you need to get to work. Car loan interest rates are generally lower than most other types of loans.
The most financially sound move would be to avoid splurging on a Bentley when a BMW will do for the time being. If you want to be able to afford the Continental that you’ve got your eye on, you’ll need something that you can pay off quickly so that you’re in good standing when the time comes.
When it comes to payday loans, credit card interest rates don’t even compare. Typically, payday loans are small-dollar loans, under $500, due on your next payday. They come with significant fees, ranging from $15-$30 for every $100 borrowed. From a long-term perspective, a $15-per-$100 fee scales up to a 400% annual rate. The only benefit of a payday loan is that it could get you out of a crisis if you don’t have a savings account for emergencies.
For people who are already in debt, bringing all of your debt into one place at a lower interest rate could be beneficial. The key to success for this strategy is to use the money that you save from having lower repayments to pay off your debt faster.
Borrowing to Invest (Gearing)
Gearing, or borrowing money at a low interest rate and investing at a higher interest rate may appear to be a solid strategy but there are risks when not managed by financial planning experts. Inexperienced investors run the risk of losing a large amount of money and being left with more debt than they started with. This option should only be pursued with the help of a trustworthy and proven financial planner.
Credit Card Reward Programs
With the countless credit card companies these days, each company tries to have something that provides some additional benefits to its customers. This often comes in the form of reward programs. The money spent using credit cards can help customers earn airline reward points, cruises, cash back and many other benefits. This can pay off well if you have a disciplined approach to paying off your balance each month. Otherwise, the interest spent on repayments sets off the value of the rewards you earn.
Budgets are a useful tool for seeing how your money travels through your accounts. They are essential for managing your money if you have ongoing debts. Take an honest inventory of your earnings and spending and make changes to optimise your finances.
How to Choose the Right Debt
You should always be conscious of which type of debt you are taking on throughout your life and protecting yourself. Being smart about the amount of good debt you take on can increase your ability to save for the future, build wealth and afford what you want in life without accruing bad debt.
This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.