It is common to have an uneasy feeling at the thought of debt. We have all heard the cautionary tales of unmanageable maxed out credit cards and personal loans. Though, for most, especially those who own their own home or have pursued higher education, debt is a normal part of life.
With debt present in our everyday lives, it is important to understand when debt is an opportunity for growth and when it should be avoided.
Debt can be a helpful tool providing long term benefits, for businesses or personally, when it is structured in an efficient way. To navigate debt, we have identified the top 3 key principles to consider when you are thinking of taking on debt.
1. Purpose
Critical to reflecting on whether debt is good or bad debt, is the purpose for which the debt is entered into, and the opportunity created therefrom. Being able to access an investment that provides financial benefits over time, or leverages you into a quality investment to an effective level is an example of a positive use of debt.
The form of Investment can be varied, whether purchasing an investment property, investing in new equipment that allows your business to take the next step and grow, or other investments that increase your personal earning potential in the future.
Types of debt to be wary of are those that fund purchases that reduce in value over time. Credit cards that can’t be repaid on time, loans for consumable items and personal loans for holidays are examples of purchases that do not increase your wealth, therefore the costs of holding the debt are not mitigated with an increase in your asset base.
2. Cost-minimisation and cost-benefit
Interest is an unavoidable cost of taking on debt, while you can’t avoid it completely you can ensure that it is limited.
Certain types of debt will generally result in lower interest rates. Loans for property will generally have a much lower interest rate than those for credit cards and payday loans. Generally, the ‘riskier’ the loan to the lender, the higher the interest rate will be. If you are able to utilise equity in an existing asset to secure the debt (such as residential or commercial property), you are likely to result in a better outcome (i.e. lower interest rate) than if you enter a contract that is ‘riskier’ for lenders (when less security is provided).
3. Tax-effective
Is the interest tax deductible? Where the debt is used entirely for income generating investments, such as a rental property, share purchases or a business loan, the interest can be a tax-deductible expense against this income. In the case of a rental property, where the property makes a loss overall (negatively geared) this may offset your other income, reducing your overall tax.
Interest on debt that is used for personal purchases such as your home will often not be tax-deductible. A single loan that has a mixed purposed (used to purchase both a tax deductible and non tax deductible item) can be problematic and reduce the overall tax saving to you. Therefore, when you are considering making both a personal purchase and an investment you should reach out to your Advisor to ensure that you correctly structure the borrowings and utilise the cash you have.
Generally, you should be aiming to limit the personal debt that is not tax effective, so that more of your overall interest costs are related to the tax-deductible purpose. Analysis of this requires consideration of many factors, past present and future, so you should always discuss the best way to structure an investment and debt with your Advisor first.
This principal also applies to when you are reducing your debt levels. If you have capacity for additional repayments, discuss with your Advisor whether and how much to focus on repaying the debt that is not tax-deductible.
Thinking of taking on large amounts of debt can be a difficult decision, and therefore one you want to ensure you are approaching correctly. If you would like to discuss your debt structure, options or opportunities, please get in contact with your Cutcher & Neale Advisor.
