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All the latest news, facts and tips from the team at Pioneer Credit Connect

25
Sep 18

Financial Freedom Mini-Series: Good debt, bad debt.

by Lachlan Hayes
Financial Freedom Mini-Series (3)

Woohoo! Congratulations on making it to the final edition of the Financial Freedom Mini-series! We hope the series has helped you feel more comfortable with your finances and given that this the final read, we thought we'd save the best 'til last.

If you haven’t borrowed money before, it's likely you at least know someone who has. In fact, between 2015 and 2016 the Australian Bureau of Statistics determined that almost 75% of households have debt. However, it's not such a surprising figure when you consider how easy it is to obtain credit cards, personal loans, mortgages, car loans or even use Afterpay!

The word debt can sound so taboo, and yes, it is one of those things we don't necessarily want lots of (if any), however, did you know that some debts can be good?

What makes a debt good?

Now I bet you're thinking to yourself 'debt is a bad thing that costs me money in interest'and for the most part, yes several types of debt are bad, but on the flipside, there are some debts that can be beneficial to you.

When you borrow money from a bank or financial institution, you pay interest on the amount you borrow which is essentially the price you pay to borrow the money. For a debt to be considered good, the goods you spend the money on should either generate an income for you, like an investment property, or add value at a higher rate than the interest on your loan, such as cautiously investing in your friends new business or having your home appreciate in value over time.

The Australian dream: is it as good as it sounds?

The most common example of a good debt is a mortgage and is based on the sole fact that the money you borrow is going towards something that typically appreciates in value over time; like a house. Put into perspective, house prices in Sydney and Melbourne, Australia's two biggest property markets, have increased by 75% and 59% respectively over the last five years. Whilst you are paying interest on a home loan, the property itself is increasing in value at a faster rate to that of your interest rate meaning that the debt is being used to benefit you.

Another way a home loan can be a good debt is by using it to generate a rental income. Consider Mark, he was able to purchase an investment property in 2014 by saving up a deposit and using a mortgage to fund the rest. He currently has a family renting the property off of him and the rent they pay covers the repayments of the mortgage AND puts a bit of extra cash in his pocket. So although he does have a debt, from a cash flow perspective he’s making money!

The business of good debt?

Another example of a good debt is a business loan. You’ve probably heard the saying “you have to spend money to make money”, and for a business, this might mean borrowing funds to grow. A business loan can give you some help to kick-start your own business or perhaps support the expansion of your current business like it did for Josie.

Josie owned a quaint little coffee shop in Brisbane and wanted to move to a bigger location so that she could increase her sales. Eventually, she found a place that was perfect, and although she had a nest egg of business savings, she still needed some extra cash to be able to renovate the new location. Using a business loan she was able to increase her revenue and profit, in turn allowing her to pay the loan back in record time. Now she’s using the extra profit to help her save up for the next big move!

The reason that this is a good debt is that the loan has enabled her to invest in herself. For Josie, her business loan has enabled her to grow her business and help increase her income, while doing what she is most passionate about.

What makes a debt bad?

Bad debt is one of those things that we have all come across in our lives, regardless if we knew it at the time or not! On the flipside of good debt, bad debt is designed to cost you money with higher interest rates whilst also keeping you in the debt cycle as long as possible.As creatures of want, we would always rather have something now instead of later, and with credit cards and payday loans being so readily available, it is becoming easier and easier to turn towards these bad debts over using your hard earned savings to fund a purchase!

Sailing into treacherous waters.

Boat loans are an example of your typical 'bad debt' because although they’re a lot of fun, a boat loan for personal use won’t put you in a better financial position. Most recreational boats, when bought new, will lose value the very moment you sign the contract, so bear in mind that if you fund the boat with a loan, you’re now paying interest on an asset that has depreciated heavily the second you tow it out of the dealership.

Take Rob and Allison for example; 5 years ago, they were both looking at buying the same new boat. Rob worked long hours and had saved up the cash and was going to buy it outright, while Allison decided she would get a loan to fund her purchase. Today, 5 years on, each boat has decreased in value by the same amount, however, Allison has discovered that she has paid around $5,000 extra for her boat due to the interest on the loan.

Whilst Allison took on debt for a purchase that would cost her money in the long run, boating was her passion and she had come to terms with the fact this was just one of the expenses of owning a boat. The best part? Because Rob worked such long hours, Allison was able to get more use out of her boat than he could!

Pioneer tip: Be very careful when taking on bad debt, and if you really need to, make sure you find a loan with features that put you in control such as having the ability to choose your loan term or make extra repayments without having to pay extra fees!

Short term gain, long term pain.

Payday loans and credit cards are the kingpins of the bad debt world. Although the two are not identical, they both share similarities which put them together in the bad debt basket. The first and often overlooked reason they are bad debts is that they are designed to keep you in debt. Often looked upon as short-term solutions, both typically have higher interest rates than other loan types and exorbitant fees for applying or missing a payment. A common trap people can fall into is constantly using payday loans or credit cards as a short-term solution, which for Matt turned out to build up a long-term problem of being stuck in the debt cycle.

Matt had his hours cut back at work and soon found himself living paycheck to paycheck. When his car was due for a minor service, he turned towards a quick cash top-up in the form of a payday loan to fund it as he didn't have the savings on hand. When it came time to repay the small loan, Matt's financial position hadn't improved and with the mounting interest, he could only pay a portion of the required repayment. This cycle kept going for the next few months until he was eventually able to repay the loan, however, ended up paying hundreds in interest and late payment charges that could have been avoided by not obtaining the loan in the first place.

So, what next?

To get you started, here are a few takeaway points which you can start to implement in your everyday life!
  • Grow your savings: the concept is simple, having a healthy savings account hand will help avoid you turning towards bad debts when you want to fund a small to mid-size purchase. If you can't afford it, don't buy it.
  • Pay off your existing debts: Do you have more than one loan or a combination of credit cards, car loans or personal loans? Consolidating these into one personal loan could save you more every month and help you pay off your existing debts even faster.
  • Be smart when taking out a loan: Aim to use credit only for purchases that will better your financial position in the future, or as we like to call them, 'good debts'.
Congratulations, you've flown through the series and we hope you loved it! If you want to time-travel back to the rest of the series, you can do so here:

Edition 1: How do other people save for a house deposit?
Edition 2: How to make tax time work for you!
Edition 3: Six savvy goal setting tips!


Disclaimer: Any information provided in this email is of a general and informative nature only. While all reasonable care has been taken by Pioneer Credit Connect in compiling this information, Pioneer Credit Connect makes no representations or warranties, whether express or implied, as to the accuracy or suitability of the information contained in this blog.