The difference between good debt and bad debt (and how to leverage it)

We’re inherently built to dread debt – no one likes feeling like they are beholden to someone else. However, not all debts are created equal. Some are said to be good debts, while others are bad debts.

In its simplest terms, a good debt helps you make money while a bad debt costs you money.

Knowing where they come from and how to balance them to your advantage can single-handedly be the difference between sailing high and dry or drowning in debt and despair.

Good debt

Remember the saying “you have to spend money to make money”? This is exactly what it refers to.

Good debts ultimately increase your net worth, even after their costs have been accounted for. Examples include:

• Mortgages: Most of us can’t afford to buy property without the help of a mortgage. Given property is a stable investment that usually grows in value over time, it should deliver you a healthy return.
• Student loans: gaining new qualifications and accreditations can increase your future earning power through promotions or career changes (assuming you ultimately use them in paid employment).
• Business loans: Borrowing to start or grow your business can help you build a source of income as well as an asset to sell in future.

Bad debt

Bad debts are ones that quickly compound and deliver no long-tern return. These include:

• Credit cards: These usually have very high interest rates (about 20 per cent or more), so they quickly balloon if not paid off in full.
• Depreciating assets: Loans used to be items that lose value over time, like cars and computers, or don’t deliver any tangible asset at all (like holidays) will cost you much more in interest than the initial purchase price and leave you with little or nothing to show for it once it’s finally paid off.
• Payday loans and Buy Now Pay Later (BNPL) schemes: These come with hefty penalties and interest – especially if you’re late making a repayment – and the debt can quickly snowball.

Tax

There are two elements to factor in when thinking about tax and debts.

Having an outstanding tax bill is generally a bad debt, since it can attract penalties and interest. However, you may be able to request a payment plan with the ATO, freeing up money to pay off other (badder) debts faster.

Meanwhile, tax deducting a debt (like the interest repayments on an investment property loan or self education expenses) can reduce your overall tax liability. As such, they may be a good debt.

Who owes the debt?

When we think of debt, we usually think about money we owe. Perhaps, though,  someone owes you money (good debt). But if they never repay it, you’re the one who loses out (bad debt).

It’s worth your while to proactively chase any money owed to you: the faster it’s repaid, the sooner you can put it to work and also eliminate the risk of never seeing it again.

Consider whether you can charge interest on it, even if just to offset the devaluation from inflation – that is, the buying power of $1 gets less over time as inflation causes things to get more expensive.

STDs (sexually transmitted debts)

Many people don’t realise that they may be held liable for debts incurred by their spouse/partner. It could be inadvertent (your partner is bad with money); hidden (gambling addiction) or deliberate (financial abuse).

Others make bad decisions because they’re blinded by love.

Always be level-headed and never leave money matters to your other half to manage alone.

Debt structuring

Even good debts can be bad if they aren’t structured properly. That could mean:

• Consolidating multiple debts into one, in order to achieve a better interest rate on what is owed and greater visibility over when repayments are due (the more there are, the harder they are to track).
• Choosing one loan type over another.
• Determining who owns the debt – you or your partner (or both of you), your business, a family trust, a self-managed super fund (SMSF), or some other entity.

This can very significantly depending on your particular circumstances and what the debt is for.

Investing in advice

A good accountant and financial advisor are invaluable – they can help you maximise good debts, minimise bad ones, and manage associated financial and lifestyle risks.

They can also help you to understand exactly why you need to take on a debt, how best to structure it and choose the right one for your particular goal.

Yes, it means another bill to pay in the short term. But ultimately, they could make you many times their initial cost in earnings gained, taxes and other costs saved, and bad debt blowouts avoided!

Disclaimer: The information in this article is of a general nature only and does not constitute personal financial or product advice. Any opinions or views expressed are those of the authors and do not represent those of people, institutions or organisations the owner may be associated with in a professional or personal capacity unless explicitly stated. Helen Baker is an authorised representative of BPW Partners Pty Ltd AFSL 548754.