Interest rates are in the news and they will stay there for a while yet. So, now is a great time to think about how you are managing your debt. Over the next few weeks, we want to provide some fundamental advice that will help you or someone you love best manage their debts.
We are also keen to avoid being Captain Obvious when we talk about debt. We would much prefer to give you some real food for thought so that you think about debt in the most useful way possible.
The first thing to Decide: Is your Debt Good or Bad?
It sounds pretty judgmental, we know, but some debts are good and other debts are bad.
Basically, a debt is good if it makes your life better, either now or in the future. In this category we include debts such as home loans, investment loans, business loans, student loans, etc. These debts are entirely rational and it makes sense to have them. Obviously they need to be managed to make sure they are sustainable. But they don’t need to be avoided.
A debt is bad if it does not make your life better. Again, without wishing to sound judge-y, this usually includes credit card debt, buy now pay later debt, personal loans that were used to fund consumption, things like that. Basically, these are situations where you have a debt but you have little or nothing to show for it.
Usually, bad debt leaves you paying higher interest. This can be because the interest is higher on things like credit cards. Or it could also be that the interest is not tax deductible in any way, such as with loans for holidays, etc.
What to do with Bad Debt
If you have bad debt, try to get rid of it. ASAP. There are some little techniques that can be used here, such as consolidating credit cards, or consolidating loans in general. If you are self-employed, you might even learn some ways to direct your cashflow towards the bad debts so that you can pay them off more quickly.
But the general principle for paying off any debt is a simple one: you need to receive more money than you are paying out, including money you are using to pay interest. You need ‘spare’ money.
This might mean you need to do some combination of two things: earn more and/or pay less. The extra money is then used to pay down the debt – as quickly as possible.
Getting rid of bad debt can also be a great way to use unexpected income, such as bonuses or inheritances. For example, let’s say you owe $10,000 on your credit card and you are paying interest on the debt at 20% per year. That means that you are paying $2,000 in interest every year. This interest is usually not tax deductible, meaning that you may need to earn a lot more than $2,000 to pay off the debt. For example, a taxpayer with a marginal tax rate of 34.5% (including Medicare levy) has to earn more than $3,000 in order to have $2,000 remaining after tax to pay the interest. (You have to earn almost $15,500 to pay off the actual $10,000 debt).
If this is you, and you were to get a $15,500 bonus somehow, then using that bonus to pay off the credit card will give you a benefit that is the same as a guaranteed investment return of 20% post tax if you were to invest the money. That’s a great return and – as long as you do not simply borrow more money again straightaway – you will continue to get that benefit for as long as the original debt would have lasted.
What to do with Good Debt
Good debt is quite different. While paying it off is often still a great idea, you do not need to rush to get rid of it. After all, it is making your life better.
Let’s say you have an investment loan for a property that has gone up in value. The interest on this loan is probably deductible, which makes it cheaper than a debt with the same interest rate that you took on for some personal reason (such as living in the same property yourself). In this case, if you were to have some ‘spare money,’ you may not rush to pay off the debt. You might use it for something special, such as a nice holiday, or you might use it to make extra super contributions or to buy some shares or some other income generating purpose. We will talk about this again in the next few weeks.
The general principle with good debt is that you only need to pay it off if there really is nothing better to do with your money. Nothing better to do with your money? Huh?
Tune in next week and we will explain.