Types of Debt
Have you ever wondered why the things that evoke the most passion or emotion in us, are usually four letter words.
Love, hate, fear, golf and some I won't mention here.
Well, here's another four letter word that most people react to. Debt!
Mostly, we are conditioned to fear debt and avoid it at all costs. So why does debt propel one family to great riches, and another to poverty?
How come many wealthy people manage large amounts of debt?
Can debt ever be positive and help us get ahead or is it always negative and something to be avoided - at all cost?
Before we can answer these questions, we need to clarify our definition of debt.
This one, very loaded word, can be used to describe three very different strategies.
Good Debt vs. Bad Debt
No doubt you have heard of good debt and bad debt, but I'd like to propose that there are actually three different kinds of debt, not just two.
So let's look at the three different types of debt and dispel any confusion surrounding the subject.
1. Horrible Debt
The type of debt we enter into to, to buy things that depreciate (go down in value) and receive no tax deduction for having made the purchase.
This is the kind of debt we should run and hide from. Horrible debt, typically credit card or consumer debt, is what many people run into every day, without a second thought.
Of course we must spend money on clothes, food, petrol etc, but could we consider not purchasing that third wide screen smart television (that we desperately 'need') on credit, and wait until we can pay cash?
Horrible debt is debt that will keep people poor. I believe the less horrible debt we take on, the better.
Reducing horrible debt
By accelerating the reduction of your horrible debt you can:
- Reduce your total interest payments and reduce the duration of your horrible debts;
- Increase the equity you have in your home, which can be potentially used as security to borrow for investment purposes later on; and
- Potentially provide you with more cash flow at the end of the loan term that can either be used to repay other debt or to make additional investments.
2. Tolerable Debt
This is debt that is not all bad and not all good!
This is debt that will not attract any tax relief, but is used to purchase appreciating assets, for example the family home.
As alluded to above, most of our industry peers and analysts tend to put all debt into one of two categories, good debt and bad debt, where the family home is considered bad debt.
I disagree with this view, and, while acknowledging that the family home is not good debt, neither do I believe that it is fair to put it into the same category as credit card debt for a wide screen TV!
3. Productive Debt
Debt that is used to invest in an item that appreciates in value and offers generous tax deductions as a result of the purchase / investment.
Investment property falls into this category.
N.B. New investment properties attract the greatest tax deductions because of the added property depreciation that is no longer available with established properties.
Australian Capital City Median Price Growth, 1970 - 2018
I recently looked at the average median price and annual percentage price growth of five Australian cities, from 1970 - 2018.
Here are the results.
Median Price Growth, 1970 - 2018
Average Percentage Price Growth, 1970 - 2018
Source: REIA / ABS / RP Data
Example Purchasing Scenario
Let's imagine you purchase a property for $500,000 and it increases in value at 6% per year.
That is not a large stretch of the imagination and could be considered a conservative estimate when you look at some of the numbers in the table above.
At 6% price growth per year, your property would take 12 years to double in value.
The Rule of 72 is a quick method you can use to determine how long an investment will take to double.
By dividing 72 by the annual rate of return, you can know how many years it will take for the asset to double in value.
e.g. 72 / 6 = 12 years
Let's say you are paying $50 per week to fund holding your property, after your tenant and the tax man have paid their share.
In 12 years, based on this appreciation, your property would be worth $1,000,000.
And you would have paid a total of $31,200 ($50 x 52 weeks x 12 years) to fund holding the property.
That means your debt has made / earned you $468,800.
Also, by the time your investment property has doubled in value, increases in your rental income will have negated the shortfall and left you with a positive cash flow investment.
Thus, the above example scenario shows just how productive debt can be. If an initial $50 negative cash flow shortfall was a problem, the strategy would be to source a property that had positive cash flow.
As you can see from this example, however, even with $50 a week negative cash flow for 12 years, the debt is certainly productive.
Can you now see that while horrible debt keeps one person broke, another person's productive debt can be a catalyst for them to create real wealth and security for retirement.
So the advice your parents gave you was essentially true. Avoid all horrible debt.
What they may not have understood, and thus not mentioned, is the incredible wealth creating power of property harnessing productive debt!
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Nick is the Founder of MRD. Nick is in his element when he is inspiring, mentoring and teaching safe and responsible finance and investment strategies.