Good Debt vs Bad Debt
My parents taught me at a very young age, that all debt is bad debt. Due to the fact that this has been ingrained in most of us, we don’t like to borrow money. Therefore, we are missing out on creating the very things we really want, such as security and financial freedom. When your passive income, including rents and dividends, are equal to or greater than the income you’re currently receiving from your job, you have the freedom to do what you love versus being forced to work.
Lets be realistic, if you’re not leveraging other peoples money (OPM) into solid investment vehicles, you’re chances of ever becoming truly wealthy does not look promising. Wondering what all of this has to do with good and bad debt? Simple, bad debt can make you poor, while good debt can make you wealthy. Let me explain.
Debt is considered efficient if it is working for you to build wealth, and is by contrast, considered inefficient if it is costing you money and opportunity. Bad debt, for example, is when you borrow money, perhaps from a bank, and buy depreciating assets; this includes things like a car, a holiday, a television, furniture and so on. All of these would usually depreciate in value over time and you cannot claim any of the interest (or other expenses) as a tax deduction. To make matters worse, you pay for these ‘things’ with after-tax dollars. example: If you were to purchase a $5,000 TV, assuming you’re on a 30% marginal tax rate, you would have to earn roughly $7,000 before tax to pay for the TV with your after-tax income. As if that wasn’t bad enough, you still cannot claim any of the interest that was borrowed from the bank to pay for it. Not so good is it? That is where debt gets its negative connotation from.
On the other hand, good debt comprises borrowing money and investing in appreciating assets, such as investment properties, index funds, gold or shares. Not only are these assets appreciating over time but the Australian Tax Office (ATO) will allow you to claim two types of deductions against some of them (such as investment properties). The first being cash deductions, and the other non cash deductions, or paper costs. Simply put, you can minimise the amount of tax you’re currently paying and use that tax saving, or rebate, to fund your investment property.
Let’s say you borrowed money from the bank and you purchased an investment property, you would be able to claim the interest paid on your loan, expenses for your investment property, as well as the depreciation on both the fixtures and fittings, and the building cost of the house itself. Now, if you take into account that you’ll be receiving rent from this property, which will be used to help fund the interest, your investment property will ‘cost’ you very little, if anything at all. Now that’s what I call good debt.
So, why would borrowing money for your own home be considered bad debt by some ‘experts’? It’s true that your own home is also an appreciating asset, just like your investment property. The main difference is that there are no tax deductions whatsoever on the interest component, or any other expenses. Not to mention you do not have a tenant paying rent to contribute to your mortgage.
What we are finding nowadays is that there are an increasing number of people who would rather buy an investment property because of its low, out of pocket costs (in an area that may be too expensive for them to live) and then rent it out. The long term plan may be to have tenants pay off the mortgage, and then once owned, the investors move in themselves. This is becoming quite a popular trend with the millennials.
Hopefully my explanations have cleared the air on debt. Yes, there is such a thing as bad debt, but it should be labelled solely on assets which depreciate, number one being your vehicle. However, as evidenced above, not all debt is bad. Some debt can even help you build your wealth- no, that is not an oxymoron. Utilising debt to purchase investment properties or shares will actually (in the majority of cases) help you build your portfolio and increase your appreciating asset base. However, one thing to keep in mind, good debt should not be seen as a ‘get rich quick scheme.’ Those who know how to properly exploit debt know that it is a lengthy-process, not a sprint. So the next time you hear the word debt, don’t cringe, it’s not all bad!