Not all debt is created equal – there is good debt and bad debt. How do you distinguish between the two? It’s important to consider what kind of future benefit the debt can bring.
Bad debt consists of personal credit cards, car loans, or even home loans. The reason these things are considered ‘bad debt’ is that you don’t get any tax benefit from this type of debt. Bad debt supports an asset that, particularly in the case of a car or a credit card, is not going to appreciate in value. In the case of the family home, it’s something that’s never going to generate you an income because you live in it. These types of debt don’t support an investment asset that’s going to grow and help safeguard the future.
Generally, the worst debt of all is credit card debt. Credit card interest rates are as high as 20%, so it’s often best to avoid carrying a credit card debt. Car loans are next, because although a car is an asset we all enjoy, it doesn’t normally appreciate in value. Home loans also fall into this category. Even though a home is an asset that can work for you in the future it generally doesn’t generate an income for you.
By contrast, investment debt is often good debt because it supports an investment asset such as a property or maybe a share portfolio. Those are the two most common types of good debt. These assets are designed to give you capital growth and income over time. Because you generate income you can often claim the interest expense on these loans against your income and offset any costs – they’re often tax deductible, in other words. They can therefore serve the twin purpose of helping to reduce your tax bill while also increasing your investment assets.
Most of us have bad debt, so it’s useful to consider ways we can use finance to turn bad debt into good debt.
For example, one way this can be done is by leveraging investment assets you already own to reduce bad debt and increase your investment debt to repurchase those assets. So if you’ve got a home loan and shares that you own outright, you could sell the shares, pay down the home loan then re-borrow and purchase those shares again. This could potentially give you the same level of investment asset exposure while turning your bad debt into good debt.
The benefit in swapping out bad debt for good is that you could increase your tax-deductible expenses on loan interest. This could then be offset against your income to reduce your tax bill, while simultaneously decreasing the bad debt payments on your mortgage. It therefore pays to examine your debts, assets and investments through the lens of good and bad debt.
James Williams is an Executive Advisor at Viridian Advisory
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