Understanding Debt

When used properly, debt can be an effective tool that may help you to achieve your financial goals. Debt can be used to purchase a range of items before you have saved the full purchase price.

It is important to understand the difference between ‘good’ debt and ‘bad’ debt. Debt can help you buy the family home, purchase a car or consumer goods and also enable you to purchase investment assets such as shares, managed funds or a rental property.

Where debt is used to acquire investments such as shares or property, this is known as gearing. This is often referred to as ‘good’ debt because it gives you the potential to claim a tax deduction for borrowing expenses and assets that will hopefully appreciate in value over time.

Borrowing to invest (gearing) simply allows you to use a combination of your own money and borrowed funds to accelerate wealth over the long-term. However it is a higher risk strategy that magnifies both the gains and losses from your portfolio. The higher the proportion of borrowed funds compared to your equity, the greater the associated risks. Options to gear into investments include margin lending, home equity loans or geared managed funds that borrow internally.

‘Bad’ debt is non-deductible debt like borrowings for consumer goods such as cars and holidays. Even though a loan for the family home is non-deductible, it should not necessarily be viewed as ‘bad’ debt because the value of the home has the ability to grow over time. But looking at strategies to pay off this debt as quickly as possible will increase your wealth.

In any case, paying off non-deductible debt before deductible debt will usually be the most appropriate course of action for many people.

The cost of borrowing can be high so you need to be disciplined and consider strategies to reduce the total interest cost, reduce the term of the loan and improve your cash flows.

Some of these strategies may include:

Making loan repayments more often

Making additional payments

Repaying non-deductible debt first

Combining loans into one account with a lower interest rate

Need advice? Contact Macarthur Wealth Management for expert financial advice in Parramatta and Sydney wide on (02) 9683 2869. www.macarthurwealth.com.au

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