What Determines Good Debt and Bad Debt? Examples and Ways to Minimise Debt!

good debt bad debt

What Determines Good Debt and Bad Debt? Examples and Ways to Minimise Debt!

In this week’s episode of the Rentvesting Podcast, we’re talking about good debt verse bad debt. We’re going to look at the ABS’s recent study of wealth in households and the results are surprising.

In this episode we look at:

  • Good debt and bad debt
  • What to look out for
  • Where debt will take you in the future

There was a recent household study on household income and wealth done by the ABS. It was surprising to see but when you think about it, it makes a lot of sense. The results of the study showed that the households with more disposable income have more debt. They broke the population into 5 brackets (20% each) in terms of income brackets. The top 20% with the highest disposable income were more likely to be in debt compared to the lowest income 20% bracket.

This does make sense because the more money you’ve got the more the banks are willing to lend you.

They’ve found that around 73% of households are over-indebted and the top 40% of people with the most disposable income make up around 50% of the over-indebtedness.

Retired people have the least debt because the banks won’t lend them money!

 

 

So let’s go through the good and bad debt.

If you’ve got two incomes, the bank will lend you more money – that is when there are two people in the household. You’re in the category of people most likely to be over-indebted. The banks are probably advertising to you for more credit cards and more loans too.

Good debt is something that increases your net wealth and helps you generate income and value – so you manage your finances a bit better and buy things to grow that wealth. The interest is deductible for most of the good debt category.

Bad debt makes you poor. It’s debt that doesn’t help you increase your wealth and allows you to purchase goods and services that have no lasting value.

 

Good debt includes:

  • Property 

It works off what’s called leverage. If you put $100k down and you take up $400k debt, you can claim a deduction. As that asset accumulates over time in value, for every percent you get, you get 5% additional growth. Here good debt can help you build wealth.

Property can also be bad debt if you’re over-indebted, having too much debt can be crippling. Just because the banks will lend you the money doesn’t mean you should take on all of the debt.

As an idea, 30 – 40% of your income should go to servicing alone but if it’s more, you’ll be in trouble.

 

  • Shares or managed investments

Borrowing money against a home or even a margin loan helps build up an asset base. While interest repayments will be made, they’re deductible and the value of the loan you took out will stay the same and the value of the asset will go up over time.

Margin calls – this is when it goes bad. The bad side of good debt is  margin calls –  one of the worst situations, if you take a loan out against shares where the value of the portfolio drops (which happens because they’re liquid as), so if it drops above a loan to value ratio above 80% and the bank tells you-you’re outside of the range, you’ll need to sell, or buy more shares to top it up or pay some debt off. None of those options are good if the shares are going down. That’s where good debt turns bad because you’re overleveraged.

Remember that over long-term things historically have gone up and short-term there’s volatility against all asset classes and it just means you’ve got to have a bit of a buffer. With the bank’s changes around investment only loans, good debt has become ‘less good’ because interest rates are higher but historically they’re still super low.

 

  • Education

This is good debt because it’s adding value to you as a person and helping you build your wealth and increase your top line/revenue. So Jayden thinks HELP is good debt because the interest is very low. But it’s important not to overeducate yourself, like doing three bachelor degrees and a Masters might be a bit much.

Louis sees debt as bad fundamentally, based on the education system where you study something and your earning capacity won’t be increased. In some industries, you don’t need a bachelor degree but you can do a diploma instead for less. There are plenty of degrees out there where universities don’t have the monopoly of information too. As the supply of individual degrees goes up, the income for individuals has gone down. Studies have shown in America for those who have gone into trades and don’t have debt are better off.

This is a double edge sword.

 

  • Owning or starting a business

Again there are two points to this, borrowing money to get a business going and starting from zero is pretty hard. A lot of people might have a good idea but no capital which is why there are sites like Kickstarter and IndieGoGo. It is a bit riskier and can cost a lot more money though. The major reason most businesses fail is not enough demand for the product and also that they are too indebted to make money. It’s always worth if you’ve got money to save up and are not starting from zero.

 

Bad debt

Borrowing to go to the shops to get a new pair of shoes or a handbag is clearly a form of bad debt, but let’s go into detail with this.

 

  • Credit cards

They’re super expensive you still pay 20 – 25% interest on a credit card. Some banks don’t even ask for your payslips and just let you set one up. They’re bad because its access to money that you don’t have. Some people get into a lot of trouble with this.

Think about trying to find an investment that can earn you 25% per year, that would be amazing. But instead, most people are willing to pay this to have a credit card. Australia’s credit card balance sits at $52billion and almost 2/3 are growing interest.

 

  • Holidays

The best thing if you’re going on a holiday is to save for it. You’ll feel a sense of accomplishment and it won’t put you far behind. If you lend money, because of the interest, you end up paying so much more back for the holiday. So often if you take out a loan and it takes you a while to pay it back you’ve almost paid for two holidays.

 

  • Cars and consumer goods

Interest-free loans are a common trap; just buying a nice new car is bad! They depreciate so quickly, so if you’re buying consumer goods they’re typically depreciative in value. If you’re serious about growing your wealth put off buying a car until you can pay for it in cash.

 

  • Borrowing to repay debt

For example, going on a holiday and putting it on your credit card and then refinancing it into a personal loan and paying it off over 7 years means you could end up paying it off twice due to interest. Not a good idea.

 

  • Gambling debt

This is clearly bad debt, we just had to add it in. It’s different to investing because it’s looking to get returns over time with minimal speculative risk. When you gamble you’ve got a lot of speculative risks where you’ll either lose everything or gain. You’ve got a 50/50 chance. It’s better to actually not gamble and put money into investments and let it grow.

 

In summary:

  • Good debt

As long as it’s growing your wealth its effective tax wise and an effective form of debt its good.

 

  • Bad debt

Bad debt reduces in value if it’s just creating a memory or won’t help you move forward and isn’t deductible then it’s considered bad debt.

If you’ve got a lot of bad debt why not put together a plan where you put every spare dollar to pay it off over a short period to cut the interest?

 

If you enjoyed this episode, please leave us a review here on iTunes or send us a question for Q&A Wednesday.

Jayden Vecchio
[email protected]

Jayden Vecchio is the Director of Red & Co Finance, awarded Vow National Broker of the Year in 2015, 2016 and FBAA Commercial Broker of the Year 2016. Red & Co Finance (recently rebranded from Discovery Finance) is a Finance Brokerage that begins with the end in mind specialising in Investment Properties. They have settled over $450M in lending over the past 3 years alone helping property investors with building and growing portfolios, reducing their risk and increasing their overall profitability.

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