The difference between good debt and bad debt
Hang on, isn’t all debt bad?
Wrong. Well, sort of.
Technically speaking, having debt means you’ve spent money you don’t have. Sometimes this isn’t such a bad thing, as long as you’re getting long term value out of it and you’re not racking up debt to the point where you can’t see a way of ever repaying it — this is always bad debt.
What makes debt ‘bad’?
Bad debt refers to money owed on things that depreciate in value or won’t help you grow your wealth in the long run. One of the most common, but least productive forms of debt is credit card debt, which can result in interest rates in the 13% p.a. to 20% p.a. range.
Car loans are another form of debt that results in paying interest on an asset that can only depreciate over time. It is not unusual for a car to be worth only 60% of its showroom price after three years.
The annual running cost survey by the RACV further suggests that, between interest and depreciation, the average medium sized sedan costs between $4,600 and $6,000 to own each year. Little wonder more urban dwellers are giving up on car ownership altogether in favour of alternative methods of private transportation.
So a good rule of thumb for avoiding bad debt is asking yourself, ‘can I afford it?’ and ‘do I really need it?’. If you answer no to either of those questions, then put those new Nikes back on the shelf and leave your credit card to collect dust in your wallet.
What makes debt ‘good’?
Debt can be considered ‘good’ when it’s used to fund an asset that has the potential to increase in value over time.
A great example of ‘good’ debt is your HECS-HELP or FEE-HELP debt, because the money you have borrowed is being used to invest in your education, which will increase your worth in the employment market and elevate your future earnings potential.
Let’s not forget that you aren’t charged interest at all on your HECS debt (it is, however, subject to indexation each year so it maintains its real value).
Another example of good debt can be an owner occupier mortgage, because in paying off a mortgage you are building equity in a significant asset that should rise in value over the long term. And there are a whole range of non-financial reasons, including security of tenure, why property ownership remains so appealing compared to being a long-term renter.
Should I dip into my emergency fund to pay off bad debt?
While we spend a lot of time preaching the benefits of an emergency fund, those three months’ worth of salary that you’ve so diligently stashed away can indeed be used to pay off bad debt. In fact — do it now.
Why? Because that cash is replaceable and it’s certainly not earning you anything material sitting in your low interest savings account, because while financial emergencies are, like flat tyres, few and far between, the credit card balance that you can’t clear in full keeps growing every minute of every day.
A good rule of thumb when managing your debt is to aim for less than 20% of your take-home salary going to meet interest payments. If you’re above that threshold, you need to seriously consider making some changes to your lifestyle.
Should I pay off my good debt faster?
Once you’ve got your ‘bad’ debt under control you might ask if you should accelerate paying down ‘good’ debt. Well, here the answers aren’t as clear cut.
Instead of asking yourself if you should pay off your good debt, ask yourself what else you could do with that money to advance your financial position.
Take a typical mortgage repayment schedule. It will likely run for between 25 and 30 years, and so anything you can do to reduce this is very likely to your benefit. But that’s not quite the whole story.
To determine if you’d be better off paying down the mortgage quicker or directing those surplus dollars elsewhere, you need to compare the effective after-tax return of both courses of action. Essentially what this means is, what is going to get you a better return?
Standard variable mortgage interest rates sit somewhere around 3.5% to 5% in Australia at the moment. Let’s assume that the interest rate on your mortgage is 4%. When considering whether to invest or pay off the mortgage (or leave it in the offset account), your threshold is that your after tax return on your investment should be greater than 4% for you to be better off investing rather than paying the mortgage.
Thus the ‘investment-return’ equivalent on your mortgage is 4%. Any investments you make that returns more than 4% p.a. is worth considering.
With official interest rates struggling to rise from their multi-decade lows, it’s unlikely that mortgage rates will rise back to the 7–9% p.a. variable rates we saw prior to the global financial crisis of 2007/08, at least not in the near term.
This means that while your natural instinct might be to eliminate mortgage debt as soon as you can (which, in the case of bad debt, is a brilliant rule of thumb to live by), it’s always best to consider your options and figure out what will ultimately be best for your money in the long run.
This could, depending on individual circumstances, involve building wealth in parallel with the family home to make sure you don’t have all your eggs in the property basket.
Get your finances in order and start with 5 simple questions in our free financial health check. Find out how much you should save, spend and whether you’re ready to invest.
Originally published at Clover Blog.