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The difference between good debt and disastrous debt

In our 'have it now' world, debt can be overwhelming if you ignore it

debt paul clitheroe good debt

Earlier this year I had the pleasure of assisting in the launch of the National Debt Helpline and the website that goes with it. I can’t tell you how important this initiative is.

Debt is not a new thing. We have thousands of years of history showing the use of debt.

Pretty obviously a business a few thousand years ago, or today, could not fund a major purchase such as a trading vessel or a large number of properties on cash alone. Equally, an individual’s ability to buy a home or a car would not happen without debt.

And debt is not necessarily a bad thing – it is the type of debt.

What is really sad is that our modern “have it now” society is driving the worst form of debt. Let me explain.

Great debt
Debt to buy a productive asset or a growth investment is in my terminology “great debt”. Sure, if you borrow too much you will get into trouble.

So, a business such as Qantas may borrow to buy an aircraft, a mining company such as BHP may borrow to put in a railway and a retailer may borrow to build a new supermarket.

Personally, we might borrow to buy an investment. Get greedy and debt, even great debt, will bite you.

But done sensibly, with plenty of research, you should end up buying a well-located property or shares. Let’s look at an investment property.

To keep it simple, let’s say you have saved a small deposit and money for stamp duty.

You buy a place for $420,000, borrowing $400,000. It rents for $350 a week but this drops to $300 after rates, agent fees, insurance and so on. So you get about $15,000. Your interest on the $400,000 is say, 5%, or $20,000. So you are out of pocket by $5000.

This loss is tax deductible. If you are a typical taxpayer, you’ll pay around 33% tax, so you’ll get a refund of about $1500 on the $5000. So the cost to hold the property is $3500. This $3500 is about “now”; do you think your property will go up by around 0.8% a year in value? Historically it will do much better than that!

But it only needs to go up by 0.8% to cover that $3500 loss. If it goes up by, say, 5%pa, you make about 4.2%, or some $21,000, a year.

Good debt

This is money borrowed to buy a non-investment asset.

This most often applies to us individuals when we buy a home. The interest on our mortgage is not tax deductible and we do not get rent because we live there. But, and it is a big “but”, we don’t need to rent elsewhere.

Over time, a well-located home will rise in value and we do tend to pay off our homes over time, giving us an asset and, when it is paid off, somewhere to live rent free.

Necessary debt
This is not ideal debt but I can live with it. It is when we buy things like a car.

This is probably necessary for you to earn a living in terms of getting to work or using the vehicle for work.

The sad news is that an asset such as a car will fall in value rapidly! But that is life. Some things we need to have. If you think a boat falls in this category, think again. See the next level of debt.

Shocking, disastrous, horrible debt
Welcome to the modern world. “Have it now” means an unlimited supply of this type of debt. I reckon it is about as good for you as a nasty, virulent cancer. It will kill your finances and the stress may well shorten your life.

You know exactly what this type of debt is. Credit card debt, store debt, payday lenders and, in fact, anyone and any place that lends you money, mainly to buy stuff you do not really need.

The stuff you buy with this debt will nearly always have no value: furniture, electrical items, entertainment and – one that really bugs me – a holiday.

That is a genius concept. Put a holiday on your credit card as you are stressed out and need a break.

Terrific, you get to come back to a credit card bill, probably at 18%. You will forget the holiday in about a week and be overrun by even more stress for years. Now that really is clever.

The National Debt Helpline and website deal with mainly this sort of debt. It is run by a not-for-profit, community-based organisation. This is really important.

Most of the “debt help” services are there to make money. This is not good news for you!

So if you or anyone else you know feel they are not getting ahead with their finances due to debt, or are sinking in debt, call the National Debt Hotline on 1800 007 007 – James Bond to the rescue. You will not be charged or sold even more expensive debt, which is what I see happening. The helpline receives funding from the Australian and state governments.

Don’t stick your head in the sand. Get stuck into “shocking, disastrous and horrible” debt before it overwhelms you.

Written by Paul Clitheroe

Paul Clitheroe

Paul Clitheroe AM is a respected financial adviser and Money’s chairman and chief commentator. He is chair of the Australian Government Financial Literacy Board, and author of several personal finance books which have sold more than 600,000 copies. Email Paul your question (must be 150 words or less).

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