Good Debt & Bad Debt
Debt is a multiplier. If used correctly, it can fast track your wealth creation, but if used irresponsibly it can destroy your finances and even your livelihood. The Australian economy relies heavily on debt to fund growth. Businesses enter into debt to fund the purchase of income-producing assets, tools and stock. Governments use debt to fund the development of expensive infrastructure projects.
Watch the KDM Debt video below for a summary of good and bad debt.
Investors use debt, too. It increases their exposure to the movements of the market through what is known as gearing. Gearing can multiply the profit of an investment, but the downside is that gearing can also multiply your losses. Gearing is also known as leverage because, like using leverage to move an object, it multiples the effects of market movements on your investment. Below is an example of the effects of leverage on return.
(Initial Investment + Borrowed Funds) x (Return on Investment – Loan + Interest) = Cash-on-Cash return
|Leveraged Investment||Non-leveraged Investment|
|Initial Cash Position||$50,000||$50,000|
|Return on Investment (10%)||$10,000||$5,000|
|Cost of Loan (interest, loan establishment fees etc.)||–$1,000||$0|
|Cash-on-Cash Return||$9,000/$50,000 = 18%||$5,000/50,000 = 10%|
As the example above shows, the cash on cash return of your investment is proportional to the level of gearing you employ whether that is positive or negative. Unfortunately, the cost of borrowing the money acts to reduce a positive return and increase a negative one.
If your intention is to build wealth, then the debt should not be avoided. But it shouldn’t be taken lightly or entered into without due diligence. To help navigate the pitfalls and benefits of debt, I have broken it down into three subcategories below:
Good debt is when a person or company enters into debt to acquire an asset; this is also known as gearing. The most common types of good debt taken on by investors are mortgages for the purchase of investment property (see the Investing in Property chapter) and margin loans (see the Equity Securities chapter) for the purchase of shares.
If the income from an asset is greater than the interest repayments on the loan and other costs of holding the asset, then the investment is considered to be positively geared. That is to say that the asset produces more income than it costs to hold. A good example of positive gearing is the use of a margin loan to purchase high-yielding shares.
Conversely, if the income from the asset purchased is less than the interest repayments on the loan, then the investment is considered to be negatively geared. This basically means that you are losing money on the asset. Although negative gearing at first appears well, negative, it does have its advantages. When using negative gearing, the investor hopes that the value of the underlying asset will appreciate in value at a rate greater than the cost of holding the asset. Negative gearing is commonly seen when purchasing an investment property.
Another way to classify good debt is that it should have an effect on your taxable income. Interest payments on good debt should be a tax deduction and income from the purchased asset will be subject to tax. I prefer not to use this form of classification as it fuels the argument that negative gearing can be used as a way of minimising your taxable income. Whilst this may be a contributing factor when deciding to use negative gearing and calculating the potential returns on an investment, it should not be the sole or even major focus of your investment.
Adviser’s Tip: All of these ‘good debt’ concepts are explored further in the Principal Place of Residence and Equity Securities chapters later in the book.
As the name suggests, bad debt isn’t good for your finances and should be avoided when possible. Bad debt is the use of borrowed money to purchase goods and services that will not provide a return on the borrowed funds. Bad debt can be described as monies borrowed to purchase luxury items. I am reluctant to use this definition as bad debt may also be used to fund lifesaving treatments or for the purchase of a car. As you can see, bad debt may be unavoidable, and some people enter into bad debt for good reasons. The distinction is used to prioritise which debt should be paid off first. Good debt is secured against an asset, repayments are often tax deductible and interest rates are usually lower.
On the other hand, bad debt is usually unsecured debt. It attracts a higher interest rate without the ability to deduct repayments from your taxable income. Therefore bad debt should be paid off as soon as possible.
Uncontrolled (very bad) debt
Very bad debt occurs when the combined annual repayments on all your loans are greater than your discretionary (spendable) income. Often the debtor is temporarily able to make up this shortfall by working more hours or by borrowing money from friends and family. Over a sustained period, the shortfall would force the debtor to enter into more debt. This occurs either through default fees and interest on missed repayments or the establishment of new loans. This, of course, would act to increase the disparity between the debtor’s income and repayments, making the situation progressively worse.
Uncontrolled debt does not just come from bad debt. Good debt can become uncontrolled debt if the debtor’s income is insufficient to service the loan. This usually occurs when a highly leveraged investor loses income due to a large dip in the economy, whilst with a small downturn, the debt would be reduced through the sale of assets. A forced sale in a depressed market may not raise sufficient funds to settle the loan. The investor may be left with a debt and no income from the assets to assist with repayments.
Due to the vicious cycle of uncontrolled debt, if you find yourself falling behind on or having to constantly work more to cover loan repayments then do not put your head in the sand. You need to take action immediately. Go to the ASIC website below and speak to a financial counselor regarding your debt. If your financial situation is grim, but not to the point of warranting government assistance, it may be wise to speak to a financial planner about debt consolidation and refinancing.
Adviser’s Tip: Go to the moneysmart.gov.au/managing-debt/financial-counselling to find a financial counsellor.