The Debt Debate - Good Debt Vs Bad Debt

Written on the 1st of July 2010 by Nicholas Sinclair

Good Debt: is generally investment debt used to acquire quality appreciating assets that also produce assessable income. Generally interest payments on good debt are fully tax deductible.

Bad Debt: is debt used to pay interest from after tax dollars and in this case interest payments are not tax deductible. Bad debt generally consists of principal and interest payments.

The worst kind of bad debt is that used to purchase depreciating assets e.g. car, boat etc. Eliminating bad debt should be a priority when aiming to achieve financial independence.

Debt Strategies......

Debt Recycling
This strategy effectively helps you eradicate bad debt faster whilst creating good debt and acquiring appreciating assets with no difference to your personal cash flow. It converts bad debt (non-tax deductible) into good debt (tax deductible). As you pay down your non-tax deductible debt (e.g. home loan) using your surplus cash flow you recycle an equivalent amount out as an investment loan and invest into appreciating assets (NB: The correct finance structure is essential). Importantly debt recycling does not alter your cash flow situation compared to just paying down your home loan.

The strategy ensures you don’t waste vital investment years of your life (early stages) and is an essential strategy for producing compounding returns.

By continuously purchasing investments over time you are also effectively reducing your investment risk implementing a strategy known as ‘Dollar Cost Averaging’. This strategy increases your wealth significantly over the long term.

Debt Transformation
This strategy is all about structuring your debt and assets in a more tax effective manner. Like Debt Recycling it converts bad debt into good debt by replacing the non tax deductible debt with tax deductible debt.

This strategy generally suits anyone who has at least 15 to 20 years or more to retirement, has a home loan with a minimum of 20% equity in their home and has surplus cash flow of a minimum of $5,000.00 p.a.

The strategy works especially well in situations where you have unencumbered investments but have non-tax deductible debt. In a nutshell the strategy works by selling the investments and paying down the bad debt and then drawing an equivalent loan to invest (good debt).

This keeps your debt levels and investment amounts the same but now you can claim the interest on the debt used for investment purposes.

There may be some issues specific to your circumstances that must be considered before proceeding with this strategy. Therefore, professional advice is essential.

Debt Structure
Your finance structure is vital to achieving your goal of financial independence. The correct loan structure is required to permit the implementation of the debt recycling strategy and allows you to use your lazy equity to regularly accumulate appreciating assets in a tax effective manner.

As with all financial decisions, you need to consult an expert to ensure that it is the correct strategy for your personal circumstances. Wealthfarm can assist you with Investment Advice, Taxation, Finance and Investment Property.

So whether you're a General Manager, Process Worker, Shop Assistant, Doctor, Lawyer, Tradesperson, Administrator, Pastor, Politician or Accountant we can greatly enhance your financial world because that's our specialty.

Call us on 1800 WORK IT for your free consultation.