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
  • 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
  • Most family 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.

Passive income