I hate the phrase ‘good debt vs bad debt’. Debt is debt. It all needs to go before you can really retire life ready. Let me explain. Regardless of what the debt (borrowed money) was used for, it will come with some type of commitment from you to make a regular repayment. That might just be the interest or it could be the principal and the interest.
Either way, there is a repayment that needs to be made and that repayment is a drag on your retirement cash flow. If you need to fund your lifestyle and your debt repayments in retirement, you’ll need even more assets to retire life ready.
Good debt
Good debt refers to money that you have borrowed to purchase an investment asset, such as an investment property or some shares. Where you’ve used money to purchase an income-producing asset, then the tax rules allow you to claim the interest you pay on that borrowed money as an expense against your income.
Where the interest cost of the borrowed money is more than the income you earn from the investment you have purchased, you can use the excess interest expense as a deduction against any other income you earn – this is what’s called negative gearing.
If the investment you purchased isn’t growing by at least the amount you are out of pocket each year, you are going backwards financially at quite a rapid pace – doesn’t sound so good, does it?
I’ve had so many people say to me they are going to use equity in their home to buy another investment property when they are fewer than five years out from retiring. When I question them on why they are doing that, they say: “to build their wealth for retirement”. But that extra debt just puts them further away from being able to retire unless they turn around and sell the property only a few years after purchasing it. The new property purchase will result in a negative drain on their cash flow.
@iamjameswrigley If you can avoid it, don’t carry debt into retirement. If you do carry debt it means your other assets have to generate that much more to support yourself and the debt. #Money #Tax #Investing #Property #Retirement #Debt
Bad debt
Bad debt is the phrase used to describe money you have borrowed to purchase an asset or a thing where you can’t claim the interest cost of the borrowed money as an expense.
Within the bad debt space, there are bad debts and there are extra bad debts.
The not-so-bad debt is money you have borrowed to purchase your own home. Yes, you pay that loan and the interest back with after-tax money – it’s not terribly tax efficient, but owning your own home is the number one thing you can do to secure a comfortable retirement for yourself. So, as far as bad debt goes, it’s not such a bad debt.
The other not-so-bad, bad debt is student HECS/HELP debt. This is a debt to the Australian Government you incur by studying a higher education (uni or TAFE) course. You pay indexing (which is just interest by another name) on 1 June each year, which is near enough to the going rate of inflation.
The long-held wisdom is that the indexing on your HECS/HELP debt will be the lowest interest rate debt you will ever have in your life, so you are better off paying other debts back first before you ever worry about your government student debt. This was true, until the sky-high indexing that occurred during the post-COVID run up in inflation, which saw student debts increase by over 7 per cent in one year.
Extra bad debt
The bad, bad debt is where you have borrowed money for consumption or to buy assets that typically go down in value.
The two classics are:
Running up credit card debt and living beyond your means (such as paying for all or part of a holiday you can’t actually afford for the ‘experience’ you will provide your family, only to then spend the next 18 months repaying said holiday at a cost of 20 per cent interest).
Buying a car you can’t afford, but you can afford the loan repayments (or so you think), so fool yourself into thinking you can afford the car.
If you are feeling overwhelmed by your debts, reach out to your bank, a financial adviser or mortgage broker who may be able to help you put a plan together to tackle it. Being overwhelmed by debt doesn’t mean you can’t turn it around – and maybe that means bringing in professional help.
Paying off your debts
Remember, we are trying to build net nest egg assets here that will, ultimately, leave you in a position to be able to retire. The equation for net nest egg assets was nest egg assets less all your debts.
If you still have a mortgage, work out how long it will take you to repay at the current rate. Will it be repaid by the time you retire or do you have some work to do on this front?
A lot of households are carrying more than just a home loan: there might be car loans, credit cards, personal loans, ATO debts… the list could go on and on. If that’s the reality in your household, it’s time to get serious about repaying those debts. The longer they hang around, the slower your progress to retirement will be.
Edited extract from Retire life ready: Practical steps to build your wealth and live your ideal retirement by James Wrigley (Wiley, $34.95), available 29 October at all leading retailers.