Good, bad, or just okay? How to know when to take on debt

With the new year well underway and the cost of living still biting, it’s prime time to look at personal finances and whether there is such a thing good debt or bad debt.

Financial services professionals usually class a debt as “good” if you are borrowing for investment purposes and where interest payments are tax-deductible, and “bad” if it is not tax-deductible.

However, this narrow definition would put your mortgage in the bad column, as this is how so many Australians work towards owning an asset. Realistically, whether a debt is good or bad depends on your financial circumstances and objectives.

I’d see a loan to build a business, generally tax-deductible, as good debt provided the loan is used to grow the enterprise. Borrowing to keep your business solvent and pay salaries or debtors would be bad debt.

Your home loan could be a good debt if it meets your personal objective of buying a family home to secure your future and once you pay down the debt to a manageable level, you extract the equity to invest and accumulate further assets outside the family home.

Both these examples might become bad if they were not meeting your objectives or were at odds with your financial situation. The bottom line: any debt is bad if you can’t pay it back.

The big no-no is credit card debt. It can be a smart cashflow strategy to use your credit card only if you always pay off in full every month. It’s a terrible debt if you rack up spending, then can’t or don’t pay the full amount monthly and get hit with eye-watering interest rates of around 20 per cent.

Credit card debt waned significantly during COVID-19 because people couldn’t go out and spend, but it has surged back up to worrying levels. Interest rate hikes make people prioritise paying their mortgage, with many using credit cards or AfterPay to plug their cashflow gap.

It’s stressful to find yourself living beyond your financial means. To get control of your cashflow, seek professional financial advice as you may be able to restructure your debt to pay it off.

It’s important to have a framework to help you decide which debts to take on. Consider why you’re investing and over what period (long or short term), also your ability to repay. Then factor in the impact if you lost your job or interest rates continue to rise.

Also consider what types of loans are accessible to you and compare the interest rates for each option (for example, interest rates using an equity access loan against property may be 6-7 per cent compared with personal loans or credit cards where rates are a lot higher).

Thinking through various scenarios helps you make an informed decision on whether to take on debt.

The important point when interest rates are at higher levels than investors are used to is that it’s more crucial than ever to keep up with loan repayments. Otherwise you risk losing that investment or having to sell and not realising the investment’s full value.

Property or shares?

Property is a popular investment in Australia, but it’s not going to meet everyone’s goals. Many people are more comfortable investing in property rather than equity markets because unlike shares, with property you can see it, touch it, drive past it and say that’s mine.

Often equity markets are perceived as volatile because the share price closes at a set value every day. But if you were to ask someone to regularly value your property, you could see similar fluctuations.

It comes back to your objectives. If you’re investing in property as an asset class, you must have a long-term view and contingency plans for servicing the debt if you lost your job or didn’t have a tenant.

Longer term, equities generally have outperformed property. There are many ongoing costs involved in property investment, including council rates, land taxes, repairs and tenancy issues. As the property ages, ongoing maintenance costs increase. If you own several properties, you may also be subject to land tax.

One consideration in a tough economy: compared to shares, property is not flexible and not liquid. If you need funds in an emergency, you can’t sell off eight square metres of bathroom to liquidate money – you must sell the whole thing.

Stress test before you take on debt

Before you take out any debt, think like a lender and stress test it. Lenders model whether you can afford to service that debt, based on your cash flow, the economy and interest rate outlook.

As an investor, you need to consider what would happen if interest rates rise by a few per cent – or more. With interest rates rising so many times in less than a year, Australia has not seen this sort of upward interest rate trajectory for almost two decades.

However, keep in mind rates are now around the long-term average. They are not high compared to 18 per cent in the 1980s or even 7.25 per cent during the Global Financial Crisis. It’s hitting harder now because property values have skyrocketed since the early 2000s and consumers borrowed more money to get into the market.

There’s also a generational shift in lifestyle and attitude to debt. Older generations were more willing to save up and live frugally until they could buy and pay down their mortgage. Younger generations are happier to put purchases on credit to get what they aspire to straight away.

The impact of “buy now, pay later” credit offerings is that young people can end up accumulating bad debt.

Getting professional financial advice and undertaking scenario planning on whether you will be able to service that debt if your circumstances or the economic environment changes will help you work out how much you’re able or willing to financially stretch yourself.

Grace Bacon is the Director of RSM Financial Services Australia (AFSL 238 282), advising clients on wealth management, retirement planning and succession planning.

Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

FOR MORE INFORMATION

If you would like to learn more about the topics discussed in this article, please contact Grace Bacon or your local financial adviser.

This article first appeared in The Sydney Morning Herald and was syndicated in The Age, Brisbane Times and WA today.

Note: past performance is not an indicator of future results.

This article has been prepared by RSM Financial Services Australia Pty Ltd ABN 22 009 176 354, AFS Licence No. 238282.

As everyone's circumstances are different and this article doesn't take into account your personal situation, it is important that you consider the above in light of your financial situation, needs and objectives, and seek financial advice before implementing a strategy.

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