WARNING: This article is about… debt. But relax! You’re about to find out that being in debt is not all bad news.
Being in debt can indeed be a crippling problem, but debt can also be incredibly useful when it comes to buying a home or a business, and some debts can be extremely profitable when structured correctly.
The most important consideration when going into debt or taking out a loan is whether the debt incurred is good debt or bad debt.
Definitions: Bad Debt vs Good Debt
Let’s jump straight in and clear up the differences between bad debt and good debt:
Bad Debt is any non-tax-deductible debt that you use to purchase depreciating assets. In other words, bad debt means consumer debt (credit cards, store cards, personal loans, car loans etc) used to purchase ‘things’ (assets) that decrease in value (depreciate) as soon as you buy them. You are borrowing money that you don’t have, and paying interest (and fees!) on that money to purchase items that will eventually be worth nothing. In addition, the interest charges on consumer items that are not purchased for business or investment purposes are not a tax deduction, so there is no tax relief for your bad debt.
Good Debt on the other hand is tax-deductible debt that you use to purchase appreciating assets. In other words, a good debt represents an investment loan used to purchase ‘things’ (assets) that are going to produce income and increase in value over time. Examples of good debt include investment property loans, share trading loans, or a business loan. And here’s the kicker: the interest component of your investment loan is tax deductible. So the tax man actually helps you pay for the loan!
But my parents taught me to pay off my mortgage as fast as possible and never go into debt for anything!
It’s possible to live without debt entirely, but there are some costs to making that choice – for example it would make home ownership impossible for most, and it limits your investment options.
You should definitely avoid or reduce bad debt as much as possible to reduce your expenses. But saving money can only get you so far, and will never generate income the way good debt can. Being debt free alone doesn’t pay the bills, it doesn’t provide a passive income in retirement, and it doesn’t pay for your food, medical expenses, or living costs (let alone spending money for your golden years if you’re imagining travel and some gifts for the grand-kids).
So being debt-free is great….but it’s just not enough, because you can’t live on it.
But I can’t afford to invest because all my money is spent on paying off my credit cards, my car loan, and my mortgage!
One of the biggest barriers that I see stopping people from making progress towards their financial goals, is the statement that goes something like this:
“I can’t afford to buy an investment property until I pay off my $30,000 credit card debt… (or personal loan, car loan, etc)”
But an investor has a completely different mindset for this problem. He or she would say:
“I’m going to invest in a property that will increase in value by $30,000 in the first year and I’m going to use this profit to pay off my credit card.”
Two completely different outcomes. One small change in personal mindset.
What about my mortgage? Is it good debt or bad debt?
Your mortgage is what I would call Okay Debt. It’s kind of in the middle of good and bad. It is most likely the largest debt you have, you are paying a huge amount of interest over the life of your loan, and the interest is NOT tax deductible, so that is bad! But your house is still an appreciating asset – it is not only increasing in value over time on its own, but as you pay off your mortgage you are also building up the equity you have in your home, and that is good!
So your mortgage is a necessary evil and we categorise it as Okay Debt and just focus on paying it off as soon as humanly possible.
So how do I get rid of my bad debt (and my okay debt) FAST so I can feel more comfortable about using good debt?
Now you’re thinking like a smart investor! Well done I’m proud of you.
Being as clever as you possibly can with how your money flows in and out of your life is the key to removing the barriers that are preventing you from investing and getting ahead. Being clever with your cash flow means making any money that you earn start working for you from the moment it hits your bank account, by applying it to the non-tax-deductible bad debt first, and paying off this bad debt as quickly as possible.
To reduce debt as quickly as possible we need to focus on getting rid of our various debts in the correct order, from worst to best, in other words we want to focus on getting rid of any and all bad debt first, followed by our okay debt, and then eventually (by the time we retire) we can think about clearing all of our good debt.
The fastest way to get rid of your bad debt is through a debt consolidation loan. If you have some equity in your home you should look at refinancing and using some equity to pay off all of your bad debts. This way you can turn all of your bad debt into okay debt immediately, and continue to pay all of your okay debt with one monthly payment at 5% interest (the interest rate on your mortgage) rather than multiple repayments at 10-20% interest (the various interest rates on your various credit cards, personal loans and car loans etc), which will save you thousands of dollars in interest, and account and admin fees, over the long term.
The Turning Point for Your Finances
Freeing up an amount of cash that was previously lost to credit card or personal loan repayments provides you with a critical opportunity – to channel this (previously wasted) money to somewhere that advances your financial situation.
Option 1: Direct the cashflow into your mortgage to reduce your okay debt even faster
Let’s take a look at this:
- Let’s say you have a mortgage of $300,000 on a 30 year term at a variable interest rate of 5%.
- If your debt consolidation loan freed-up $400 per month in repayments that you were paying on various credit cards or personal loans, and you simply channelled that same $400 per month onto your mortgage, you would pay off your mortgage 10 years and 4 months earlier, and save a staggering $111,939.00 in interest!!
Option 2: Direct the extra cashflow into an investment property
- The extra cashflow you have freed-up could be used to start investing for your retirement. Investing in a property could cost you as little as $13 per week to own thanks to negative gearing (see an example with real numbers), so this is your chance to put your windfall to good use and start doing something about your retirement plans.
- Or if you simply cannot bear the thought of spending $13 per week on your retirement plans, you could switch strategies and purchase an investment property that is going to cost you $0 per week to own and instead put $33 per week back into your pocket (or even better, back onto your mortgage!). See how the numbers work for a positive cash-flow property here.
So we’ve turned some of our bad debt into okay debt (a lower-interest loan), and some of it into good debt (new investments). Not only is our new investment building our wealth over the long-term, but our interest payments are now tax deductible.
Option 3: Invest it into anything!
The point is that money that used to go straight to your credit card company is now building YOUR wealth.
Just by getting a little smarter with where your money flows, and without affecting your current lifestyle at all (notice I haven’t mentioned budgets or spending cuts once), you have ‘freed-up’ the extra cash flow you need to pay off your mortgage faster, or invest, and finally get started on that property portfolio or retirement plan…
We do 1-on-1 Financial Independence Workshops for $295. We improve your finances on the spot by exploring all of the strategies in this article and more. We guarantee that we’ll make you $5,000 in saved interest and tax on the day, and we do this with confidence because we have a 100% success rate in 2015. Full details and results here…
Andrew Clough | Ph: (07) 3510 2122 or contact me via email here
Main Street Group | Level 1 Highpoint / 240 Waterworks Road, Ashgrove QLD 4060