For most people, debt will be a feature at one (or many) stages of their lives. There are many types of debt, some of which are positive, and many which can have a negative impact on your financial health, and your lifestyle.
Many people are unaware of the levels of debt that they have and the impact it creates on their lives. Often clients come into our offices with the best of intentions and want to get involved in investing in different assets, such as shares, exchange traded funds (ETFs), managed funds and investment properties. Sometimes these clients also have existing debts, and are unsure as to whether they should invest now, or pay off this debt before looking to invest.
Let’s have a look at some different types of debt:
1. Mortgage on Own Home:
A mortgage on your own home is a non-deductible type of debt. As you are living in your own home, you are unable to claim any tax deductions on this type of debt and therefore is often thought of as a necessary evil to afford your own home. Interest rates can range between 4-5% – sometimes a little less, sometimes more depending on the bank and the type of loan.
There are two schools of thought when it comes to mortgage debt. Some believe that owning your home without a mortgage (i.e. no debt) is wasting valuable capital that you could use to invest in other things. Others believe that paying off your house means that there is no more interest being accrued in non-deductible debt and therefore you can focus on investing into other assets that are perhaps more tax effective, or can deliver investment returns.
The way that I look at this debt is: say, for example, the interest rate on your mortgage is 4.5% and you have an additional $10,000 to either invest in another asset or to pay off the mortgage. Would you rather pay off the mortgage or invest it somewhere else? The bottom line is that by putting that $10,000 towards the mortgage you are guaranteed a return of 4.5% per annum; that is the interest that you save by paying down the mortgage. You could, however, get a higher return, let’s say 8% in Australian Shares. This 8% however is really a net 3.5% as you had an opportunity cost of 4.5% – you chose not to pay down the mortgage. And what happens if the markets do not deliver 8% – perhaps only 4%? In this case, you may actually lose money when you take into account the interest that is still incurred on the mortgage.
2. Investment Property Loans:
Investment properties can be a great tax-effective investment depending on the actual property, rental returns, and your personal circumstances. There is widespread debate as to whether negative gearing is good or bad and whether it will be allowed to continue with the existing tax benefits. With a negatively geared property, the benefit is that the difference between the cost of the loan, and the rental income associated with the property can be tax deductible, along with many other expenses, including depreciation. For many people it can lower their taxable income and therefore ‘save’ them money in tax that they can then use either to pay down their loan quicker, or use for other investment purposes.
Some invstors in negatively-geared properties will take out an interest-only loan, which essentially ‘rents’ the property from the bank, as they do not pay down the principle loan amount. Investors often intend to wait for the property value to rise and then sell it, so they do not want to put too much of their own capital into the investment whilst waiting for this to happen.
This debt can be seen as acceptable as it can be used to build wealth can have taxation benefits.
3. Credit Cards:
Credit Cards single-handedly create the most havoc for households out of any debt type. There are a number of reasons for this, which all stem from the regulatory management of credit cards in Australia and the rest of the world. To get a credit card is particularly easy for many people, and providers regularly offer higher credit limits, enticing clients into spending on the cards to receive points and awards. Conveniently, the small print (and there’s lots of it) is often at the bottom of the documents, or in attachments, and it’s in there that you find the real terms of the credit card and the actual interest rates that you accrue when you spend money, or even worse, take a credit card cash advance. Don’t be surprised to learn that your credit card has an interest rate of somewhere between 15 and 22%, with cash advances often costing more. Also, did you know that the minimum credit card monthly payment is designed to never pay the card off?
Credit cards are the worst form of non-deductible debt and can spiral out of control very easily. For example: if you have a credit card debt of $20,000 and pay $500 per month it will take 32 years and 2 months (at an interest rate of 13.24%) to pay it off, and you would have paid $23,823 of interest over that period.
If you have any credit card debt, there is no point in investing in any investments until you have paid this off. There are very few investments that will deliver more than a 10% return consistently.
4. Personal Loans:
Personal loans are similar to credit cards, in that they are non-deductible debt, and should also be paid off sooner rather than later. Just be careful of any early payout fees and look into the terms and conditions carefully.
5. Car Finance:
Depending on your personal situation, car finances can be effective or ineffective. An example of effective car financing is if you own your own business, you may be able to claim the car finance as an expenses and it may become tax effective.
If you simply want a new car, there may be other ways such as salary sacrificing, or leasing which may work best for you. It is best to consult your financial adviser or an accountant to discuss this further.
6. Margin Lending:
Margin Loans allow you to borrow money to invest. They can be effective in upwards markets, magnifying your returns as shares rise, however can also come with significant danger, in terms of the dreaded words ‘Margin Call’. This is where the value of your shares have dropped below the tolerated margins by the lender, and you either need to sell some of the shares to create more of a cash buffer, or you need to tip more of your own money into the loan to build the buffer.
Personally, we do not advocate for investors to borrow money to invest via margin loan.
There are good and bad types of debt, and the definition also depends on your personal situation, which is different for everyone. However the key things to remember are:
1. Get rid of that credit card debt!
2. Pay down non-deductible debt before deductible debt
3. Credit can be good in certain instances, but keep it on a tight leash
4. When investing, look at your personal situation and determine whether your funds are better off paying down a debt before investing.
Quest Advisory Group is a Perth based financial planning firm. We are holistic in our financial planning and can assist you with everything from budgeting through to investment portfolios and personal protection insurances.
For more information, please contact us on 1300 120 455