In the world of finance, there is both good and bad debt. That might come as a surprise to some people who see debt as inherently bad and try to avoid it at all costs. But it’s rarely possible to go through life without having some kind of debt. Most of us can’t pay upfront for important purchases in life, like a car, a university education or your first home.
Debt is a tool that can be used smartly as long as you have a good understanding of it. Before you take out a loan or buy on credit, you need to know whether the debt you will incur is good or bad. Simply put, good debt is put towards an investment that will grow in value or provide income. Bad debt represents borrowings that depreciate in value or provide no income.
Examples of Good Debt
Good debt is usually used to acquire assets or investments that provide you with a long-term return on investment. These are strategically acquired in order to generate income and/or go up in value.
Good debt supplements the cost of borrowing over time to actively help you build long-term wealth. In other words, you’re better off with it than without it.
Some examples include:
● Home loans – Borrowing money to buy a home is good debt because the property is likely to increase in value. It also allows you access equity for further investments and when you sell your PPOR (principal place of residence) it is exempt from capital gains tax imposed on other investments.
● Investment properties – Investment properties generate income through rent while increasing in value. Various expenses are also tax deductible. The overall debt is generally held for a short time, while the income generated can be very high.
● University degrees – Taking on a student loan is good debt as it is interest-free and benefits the student in the long run in the form of higher income job opportunities. This is automatically deducted from your pay once an income threshold is reached (currently $19,084).
Examples of Bad Debt
Bad debt is much more common, usually referring to money borrowed for personal consumption or to purchase assets that will not generate income, don’t have any deductible expenses and/or will depreciate in value over time.
● Cars – Borrowing a large sum of money for an expensive car is a prime example of bad debt. A car reduces in value rapidly the moment you buy it, with an average value reduction of 19 per cent in the first year of ownership.
The cost of running a car in New Zealand can be as expensive as a dollar for every kilometre driven, including depreciation, interest rates, petrol, insurance, repairs and maintenance.
So if you bought a car for $20,000, it will be worth $16,200 after one year. If you drive 8,000 km in the year, the running cost combined with an interest rate of 10 per cent amounts to $10,000 a year until the debt is repaid.
● Credit cards and personal loans – Borrowing money to buy consumer goods, pay for everyday expenses or to fund a holiday are all examples of bad debt. You’re making existing costs become more expensive the longer you hold onto the debt.
An example would be if you went on a $3,000 holiday funded by your credit card with an interest rate of 15 per cent, which would incur an additional cost of $450 a year until it’s repaid. If credit is used to pay for multiple things, the accumulating debt can stack up and have damaging consequences.
Bad debt can’t always be avoided but it is crucial to minimise it and avoid it where possible. Develop a financial strategy that puts you in the best possible position before you take out a loan. If you do incur bad debt, pay that off first starting with the highest interest rate loan. Another option is to refinance, rolling all your loans into one so you have a better interest rate or payment plan.
Keep in mind that good debt still comes with significant risks, requiring research and planning to ensure you’ll truly benefit. For example, a lack of rental demand might undermine the benefits of your investment property or you may take on a student loan for an occupation that has low demand. Make sure you are well informed before taking on loans and consider your personal circumstances as well as events out of your control such as interest rates.
If you would like professional and independent financial advice, get in touch with Wealth Health. We can offer unbiased recommendations on what best suits your budget and situation. We are based in Papamoa and can visit clients in Tauranga, Waikato, Mt. Maunganui and the wider Bay of Plenty.
If you want to pay off your mortgage at a faster rate, we can help. Call Craig on 027 667 2537 or contact WealthHealth online. Alternatively, we provide excellent information in our Frequently Asked Questions section.