Winning ways with debt

Some debt is good for finances and some is bad. Money magazine founding editor Pam Walkley shows how to make debt work for you, not against you.

If you’re carrying a lot of debt you’re not alone. Australian households are the most indebted in the world, and their debt has risen to 123 per cent of the nation’s economic output, according to LF Economics, based on official data. Put another way, our household debt level is

1.9 times the total household income.

Rising debt is not all bad news, it depends on what we’re borrowing for. Some debt is necessary for most of us to get ahead. Learning to use debt intelligently can make a huge difference to your personal bottom line.

If you want a good education as a younger person, or upgrade your skills when you are older, it’s likely you’ll have to borrow. Most people can’t buy a family home without a mortgage, or a car without a car loan.

These are examples of good debt, because you’re borrowing to accomplish something that should provide a long-term pay-off.

Keep control

Bad debt is usually shorter term, but the loan often lasts far longer than the item or experience you bought; think expensive holidays, dining out in pricey restaurants and designer clothes. There’s usually no financial payback on this debt either.

Borrowing to buy an investment, whether shares or property, is good debt. An investment property, for example, should grow in value by more than inflation and provide rental income. Also, mortgage interest and other expenses can be claimed against your income, reducing your tax.

If you’ve built sufficient equity in your family home, consider consolidating by transferring debt from credit cards and personal loans onto your mortgage, where the interest rate is considerably lower. But using good debt to pay off bad can cost you: you could be spreading the cost of your holiday over 20 years, dramatically increasing your total interest payments. This strategy only pays off for those disciplined enough to increase monthly mortgage payments so the term of your home loan is not extended.

Shrink debt

If you don’t want to use your home equity to consolidate, you’ll need to consider other ways to shrink debt. First, tighten spending to provide surplus income. Logically, paying debts with the highest interest rates first makes sense. Some prefer paying off a smaller loan faster, even if it has a lower rate, because it gives them the impetus to continue reducing debt. You could consider a credit card with a zero-interest period, but these only work for the disciplined (see breakout).

Credit cards are not themselves evil. A low-rate card with a low maximum balance can be a good budgeting tool. But racking up debt you can’t pay off in full each month on a high-rate card will end in tears. For example the credit card calculator on the MoneySmart website (moneysmart. gov.au) shows if you have a $10,000 debt on a 18 per cent interest card and make only the minimum payment each month (starting with $203 in the first month) it’ll take almost 44 years to pay off and you’ll pay $36,332. Increase the repayments to $492 a month and you would pay off the debt in two years, paying $11,805.

First, tighten your spending to provide income.