Good Debt vs Bad Debt and How To Make It Work For You

When it comes to debt and property, most people would rightly assume that it’s the loan associated with the property. However, a common misconception most people hold is that all debt is bad.

What if I told you, there’s such a thing as a good debt and you can use it to your advantage to increase your wealth.

For a savvy property buyer, good debt is any borrowed money which is used for investment purposes. Mind you, not just any investment i.e. buying part share is a greyhound syndicate doesn’t qualify as a good debt, the investment has to be income producing with a strong potential for capital growth over time.

A good example of what qualifies as a good debt is, mortgage loans for investment properties, be it residential or commercial.

When taking a mortgage, you’re borrowing to buy a property that, based on your research, shows potential to appreciate in value over time, and interest portion of your mortgage repayment may be used to reduce your overall tax. (Your accountant should be able to advise you regarding this and other tax offset advantages where depreciation is claimable).

However, be careful not to get too bogged down with negative gearing benefits fascination, a simply way to consider negative gearing is, you are paying a dollar today in the hope of getting 30 cents back at tax time.

When it comes to funding an investment property, too many borrowers tend to focus on wanting an interest only (IO) loan as they want to pay as little as possible in loan repayments while waiting for the property value to appreciate and al whilst receiving rental income and depreciation benefits.

If your aim is to be a successful property investor and retire on rental income from your property portfolio. You need to balance this strategy against the fact the that IO loans eventually expires, typically in 5 years. And the new principle and interest (P&I) repayments on the outstanding loan balance will be higher than your IO repayment as the original loan now needs to be repaid over a shorter loan term.

It’s important to note, if you intend to borrow for a mortgage, any bad debt you may have, has the potential to reduce your borrowing capacity as lenders will factor in any outstanding balance and repayments due when assessing your loan.

Bad debt works against you from the onset, debt such as credit cards (including interest free & buy now, pay later facilities) and personal loans (including car loans, which are considered to be unsecured debt even if the lender has taken that vehicle as security) limit your mortgage borrowing capacity.

Let’s take a closer look at some of the typical bad debts available and how they decrease your chances of getting a home loan.

• Credit Cards tends to have high interest rates and will cost you substantial money over time if you choose to make only the minimum required repayments. If you use them, you should make a habit of paying them off every month so you aren’t accruing interest and creating a potential debt trap.

When a lender assesses your home loan, they assume that you have maxed out all your credit cards and factor your credit card repayment as an existing debt commitment based on this.

What this means, even if you pay off your monthly credit card balance diligently, a smaller portion of your income in available to service the mortgage as lender assumes a maxed-out credit card needs to be paid from your stated income as well.

• When buying a new car, you’re borrowing for something that immediately starts losing value as soon as you drive it off the lot. I am not discouraging you from buying a new car, consider this, a slightly used car, 1-3 years old, is usually more cost effective and potentially the same design as the newer model.

And if you have to finance the used car, the loan value is likely to be lower than what you would have needed for a new car. Most lenders offer the same interest rate for new and near new cars, and a lower loan amount will allow you to pay it off quicker.

Lenders look at car loans slightly differently to credit cards. Unlike a credit card, lenders know that you will pay off that car loan over a set period and here lies the problem.

Unlike a mortgage which is over 30-year term, car loans tend to be over 5 years, which means that the car loan repayments have to be significant in order to pay off the loan over the shorter period. And again, this means, income available to service the mortgage is reduced which in turn mean that your borrowing power is reduced.

Finally, when compared to a ‘bad’ debt, ‘good’ debt such as an investment loan has lesser of an impact on your total borrowing capacity. The reasoning behind this, income produced by the investment purchased using the ‘good’ debt is going towards (some if not, most of) the repayment required on the ‘good’ debt.

With this in mind, if you want to borrow to buy property, choose what kind of debt you apply for wisely.