Contrary to popular belief not all debt is created equal
Think all debt is destructive? Not necessarily. Effectively managing good debt can go a long way to helping you achieve your financial goals.
Good debt can be used as a tool to grow wealth, while bad debt can financially cripple you. If you think of debt as a car, good debt takes you on a highway leading to the beach while bad debt stalls your car so that you aren’t even able to leave the parking lot. You are always the driver: debt is only a useful tool as long as you’re in control of the steering wheel.
The easiest way to tell the difference between good and bad debt is to look at what you’re using credit for. Good debt generally uses credit to buy assets or generate an income in order to grow wealth, while bad debt often uses credit for consumption such as buying that extra pair of expensive shoes or treating yourself to an impulsive luxury cruise. If your debt is a result of fulfilling day-to-day “wants”, it is likely you’re misusing credit.
According to the Reserve Bank of New Zealand, household debt now stands at 126 per cent of disposable income, excluding rental properties. A Canstar report calculated a national interest-bearing credit card spend of $22.9 billion at a rate of 19.24 per cent for 2016, and this trend is said to continue.
From credit cards to mortgages and student loans, here’s how to tell if you have good debt or bad debt – and to move towards finding ways to manage debt more effectively.
Credit cards typically incur high interest rates, annual fees, and withdrawal fees. Rewards associated with credit cards, such as cash backs or Airpoints Dollars, are often minimal compared to the costs you’re likely to incur collecting them.
While a handy tool for convenient spending, credit cards can be considered bad debt when used for living expenses or “wants” rather than “needs”. The key to effectively managing a credit card is to pay it off every month. When you’re paying your full balance when the bill arrives, or over a short space of time, you’re using your credit card as a good debt tool.
Vehicle financing can be seen a good debt, as you’re buying an asset you need, and one that potentially helps you earning an income. However, this all depends on your car loan’s interest rate and terms. Be sure to review your vehicle financing deal for all hidden costs and penalties. You’d like to be in a position to be able to pay the loan off early without penalty.
The biggest mistake to avoid when it comes to car loan debt? Not funding the car over life of asset. Never pay off an asset with a lifespan of only five years over a 10-year period. In this case, good debt means you’ve paid it off over five years or less.
Student loans are typically seen as good debt, as you’re investing in your future. Hopefully, your studies will increase your prospects of a high income and so it’s a worthwhile expense.
And if you are a New Zealand citizen or resident, you could qualify for an interest-free government loan that only becomes payable once you start earning over a certain threshold.
Mortgage or home loans
As you’re likely buying an appreciating asset, a home loan can be considered good debt. But again it comes down to the interest rate, fees, and terms of the loan negotiated, and how quickly you are able to pay it off. The rule of thumb is to ensure your monthly repayment does not exceed 30-40 per cent of your gross income. It’s vital not to overextend your borrowing.
Explore with your financial adviser the option of an offset arrangement, or a revolving credit facility. Paying in any extra cash over and above your instalment – even $10 a week – can go a long way towards paying off thousands over the full term.
Consider spreading your interest rate risk by opting for a fixed rate loan. It will protect you against any increase in interest rates, and help you budget more efficiently from month to month.
If the purpose of your loan is to grow, expand or develop your business, it can be considered good debt. When investing in infrastructure, debt can be an appropriate tool to build long-term wealth.
What converts this to bad debt is not paying for this over the lifetime of asset. For example, it doesn’t make good business sense to pay off an asset with a five-year lifespan over a 10-year period – as you’d effectively still be paying for it after it has served its purpose.
The most common mistakes people make when managing debt
Spending more than you earn
Don’t take out a loan you can’t afford to repay – especially for a “want”, not a need.
Not negotiating on interest rates
Always, always shop around. And don’t be shy to ask: “Is that the best rate you can offer me?”
Not reading the full terms of a loan
Make sure you assess the package structure, terms and support offered.
Not factoring in the hidden fees
The interest rate may be low, but the annual account fees may be high. Ask for all costs.
Thinking ‘interest-free’ on hire purchase means ‘zero cost’
While that lounge suite may be interest-free, watch out for set up and administration fees. These can mount up and equal to quite a high overall cost of credit.
Neville Whitworth is a financial adviser with the Lifetime group based in Tauranga. With over 30 years’ experience in the industry, his areas of specialisation are Business, Property Finance, Rural and Residential lending plus Business Financial Reviews.