In recent years the word ‘debt’ has developed something of a bad name, but the truth is that not all debt is bad – in fact some types of debt can do you a power of good.
Going further than that, ‘good debt’ is one of the best ways to start leveraging the power of your money and to create passive income streams that help you develop real wealth. Without debt very few people would own a house or be able to use their earnings to start building their ‘empire’.
Here we take a look at the steps you can take so that your debt serves you well, rather than endangering your financial future.
The Differences between Good Debt and Bad Debt
It’s important to understand what we mean by ‘good’ debt and ‘bad’ debt.
Good Debt is the type that allows you to accumulate assets that will increase in value; the loan interest is often tax deductible and you can use the income derived from the asset to repay the debt.
Examples include property, shares and investing in managed funds.
Bad Debt is the type that buys goods, services or assets that have no potential to generate any income and/or depreciates in value. The loan interest is non-tax deductible and there is no income from the asset to pay back the debt.
Examples include credit card debt (if not repaid within the interest-free period), personal loans to buy cars and some home loans.
Using the Power of Good Debt
There are a number of steps you can take to get your personal finances in a position to start using good debt to create wealth. Here are seven of the best:
1. Debt Consolidation
Servicing multiple debts is probably costing you way more than you need to be paying in interest and fees. It can often benefit you, for example, to increase your mortgage and use the extra funds to pay off other, inefficient bad debt like credit card balances and personal loans. Your home loan repayments may stay the same but you will be using its lower interest rate to pay off higher interest debt.
2. Making your Savings Work Harder
Many people like to keep money in a cash savings bank account as ‘emergency’ funds or a ‘buffer’ which makes them feel more secure. The fact is that this money could be more wisely kept in an ‘offset’ account, linked to your mortgage. You will earn a higher after-tax return, as well as reducing the term of your home loan, all without locking up the funds.
3. Better Cash-flow Management
Managing cash-flow is key to minimising bad debt. The main idea is to reduce interest payments – this can be done by increasing frequency of payment on a mortgage, increasing the amount paid, paying your entire salary into an offset account or by using an interest-free period on a credit card to pay for daily expenses (freeing up other funds for paying off your home loan) without paying any interest.
4. Borrowing to Create Wealth
Once you’ve minimised the bad debt it’s time to start creating some good debt. This is called “gearing.” Providing you invest wisely and your assets increase in value, gearing helps you create wealth, as the income (and capital growth) from the investment pays off the debt and exceeds the costs of servicing that debt. Property or shares are often a good strategy here. You can create the extra funds by borrowing against equity in your home, taking out a margin loan or by investing in a managed share fund.
5. Using Lump Sums Wisely
Occasionally you may receive a large lump sum of money from bonuses, inheritance etc. Try to use this to pay off bad debt and then borrow the same amount for investment purposes – this is called ‘debt transformation’ and it creates income and tax advantages that will help you start to create wealth.
6. Debt Recycling
Debt recycling is where, as you pay off your home loan, you redraw the equity you have built up to invest in shares or other property; again, the bad debt becomes good debt that can earn you an income and can be used to pay back the loan, as well as providing tax breaks. Any excess income can also be fed back into your home loan to pay that off quicker and make further interest savings.
7. Invest in a Managed Share Fund
A managed share fund is ‘internally geared’ so that you don’t have to take out an investment loan yourself, yet you can still benefit from the ‘gearing’ effect of borrowing to invest. Here the fund manager borrows (at wholesale rates) on behalf of investors to invest in international or local share markets.
With all of the above steps it’s important to get quality advice and to understand the risks and the potential returns. If you would like to review of your financial strategy feel free to contact me on 02 9929 3343 or email@example.com for more information.