For many, it’s only natural to be cautious when contemplating debt. However, is debt really that scary? That answer can really depend on you as an individual and your circumstances.
The best way to understand the implications of debt and whether it can help or hinder your own investment strategy, is to look at it from all angles, as well as closely reviewing your own financial position with regard to servicing any debt you may decide to use for investing.
So, what exactly is debt?
According to the Oxford Dictionary, the phrase ‘debt’ comes from Old French and has early Latin origins. The term means ‘The state of owing money’. Given the word is so old, the concept of debt has clearly been around for a long time – but what does debt mean in the modern context?
The most common type of debt many of us have is via Credit Cards. You pay for an item, using a facility set up by a Financial Institution, store or business which allows you to pay the amount back in 30 or 60 days. During that period, you are carrying a debt that is owed. It’s a sum you have essentially borrowed from a Lender to fulfill your purchase.
Other common ways to accumulate debt are via financial instruments such as lines of credit, long term loans such as personal, home, investment or student loans, short-term loans (often used by businesses for cashflow), and alternative financing (such as leasebacks, cash advances, asset based loans, peer to peer loans and crowdfunding).
Good debt vs Bad debt
It’s important to realise that while much of the noise around debt is negative, not all debt is necessarily bad. Why? Well if you use debt to generate long-term income, then it can be classed as good debt.
Planning carefully and having a goal prior to taking debt can also pay dividends. This is where the concept of “It takes money, to make money,” can bear fruit. While in certain circumstances you may on paper owe a large amount of money, this doesn’t necessarily mean you are carrying a bad debt.
Taking on debt can also be an excellent business strategy if you wish to add scale to your business and expand. What is crucial to assess is whether your financial position or that of your enterprise is strong enough to cover and repay that debt. Not being able to repay, can result in an otherwise good debt, turning into a bad one.
Examples of good debt can include:
- Educational loans/student loans – As your study can impact your ability to earn a stable income later in life or increase wages, taking on borrowed money for university, tafe or training can be beneficial.
- Home mortgages – Having a roof over your head that you are paying down can be classed as good debt. Even with homes taking a long time to pay off meaning you will pay a significant amount of interest on your debt, the key idea and aim is that your home will increase in value over time, enough to cancel out your interest costs.
- Home equity loans – These loans allow you access to the equity in your home and can be considered good debt (or better than bad) because they free up capital and can have lower interest rates when compared to car loans or credit cards.
- Investor loans – Loans for property investment, shares, funds and other assets that may appreciate over time is a good way to generate wealth, particularly if your portfolio begins to grow and effectively becomes positive geared – that is, the money it generates, pays for your loan.
- Commercial Car loans – While it is true that cars depreciate in value and car loans can be a bad idea for personal use, a vehicle that is used for business/commercial can generally bring with it taxation benefits. This is because the interest you pay can often be claimed as a business expense. So, you can make tax deductions based on its use. Bearing in mind it is best to pay down this type of loan quickly as interest rates can be higher.
Examples of bad debt can include:
- Payday loans – This type of borrowing, where you are lent money based on your future pay cheque, can turn toxic if not carefully managed. Particularly when you consider that the interest rates a payday lender charges can be many times that of most other lending rates.
- Personal loans for clothes or holidays – Borrowing money for things that won’t generate income or appreciate in value is something that can turn into an unhealthy habit if done regularly. Some personal loans can be good debt – such as when you are consolidating debt, however borrowing for luxuries is something to think carefully about.
- High interest credit cards – Credit cards can be 3, 4 or more times higher than a home loan rate at time of writing. Repeatedly relying on credit cards can create a snowball effect that can be hard to stop.
Asking yourself how to get out of debt, can more easily be avoided in the first place, by avoiding the bad debt above, and managing the good carefully.
Investment strategies with good debt
When it comes to any investment strategies and sound money management, it’s important to remember that everyone’s financial situation is different and it’s a great idea to develop a financial plan and investment strategy that best suits your circumstances. Looking ahead to the future with a strategy to invest in high performing, stable assets that have done well over time or are placed in strong assets is another.
Taking on debt to fund your investing should be done under careful consideration, or sound advice from a licensed financial adviser, however it can be a great way to accumulate a larger portfolio, in a much shorter length of time than can be done immediately with your savings. It is however important before you take on debt to invest, which is also known as ‘gearing’, to look at your own risk profile and to also explore the levels to which you are prepared to go into debt and still be able to live comfortably, budget for expenses both expected and unexpected, and service the loan itself.
The material on this website is intended only to provide a summary and general overview on matters of interest. Trilogy is only licensed to provide general financial product advice on its own products and does not consider your objectives, financial situation or needs when providing any information or advice. You should consider whether the advice is suitable for you and your personal circumstances and we recommend that you seek personal financial product advice on your objectives, financial situation or needs and obtain and read the relevant product disclosure statement before making any investment decision. Please note, Trilogy is not a tax adviser and information on taxation benefits is general only and should not be relied upon.