Why you should know the difference between good and bad debt
It would appear that we Aussies aren’t shy when it comes to swiping our plastic at the cash register. As a nation of credit card users, we’ve racked up over $40 billion and counting, with the average Australian paying around $750 interest per year!
But this isn’t another doomsday article about why you shouldn’t use credit. In fact, we want to help you understand that when managed properly, debt can be an excellent financial tool. The truth is, many of us will need to borrow money in order to purchase a home, obtain a tertiary qualification or reach other life goals. Debt also has an important role to play in investment planning, enabling you to purchase income-producing growth assets, such as shares or property, to boost your long-term wealth.
The kinds of investments just listed are what are referred to as good debt because in the long run, you will profit from these initial costs. For example, while debt may play a part in allowing you to get your undergraduate degree, in a few years time you will (presumably) be able to earn a much better income and be in a better financial position because of it.
Bad debt however, rears its head when credit is used on a regular basis to cover basic living costs or to purchase assets that depreciate in value, such as a car. These situations quickly go from bad to worse when an aggressive interest rate is applied and there’s a lack of repayment planning.
When interest rates go up most people’s first thought is their mortgage repayments and often the increased interest on their credit cards can sneak by unnoticed. Most major cards have an interest rate up to 20% per annum and if you’re paying only the minimum repayment amount, chances are you may be losing the battle with bad debt.
If your current financial situation means you’re unable to pay off your credit card (or cards) in full every month, are juggling multiple high-interest loans or are feeling overwhelmed by your credit commitments, it’s time to reconsider your financial direction. Unfortunately, the nature of interest means sticking your head in the sand will only worsen the burden of your debt in months and years to come.
While everyone’s circumstances differ, these simple steps are a good starting point to get you back on track and back into the realm of good debt.
- Restructure your debt by consolidating what you owe at the lowest available interest rate. Keep ONE credit card for emergencies only and cut up the rest!
- Identify how much you need to be paying off each week, fortnight or month in order to get ahead and structure your budget around meeting these commitments every time (not the other way around!)
- Beware of ‘interest free’ offers. While it may sound like you have plenty of time to pay off the balance, a lot can happen over 30 or 50 months so you need to be confident that you can afford to pay off the entire balance by the end of the contract or risk being hit with a hefty interest rate!
- While you’re getting yourself back on track, make a commitment to only invest in new loans that fall within the category of ‘good debt’ and can be justified by future profit.
- Be careful of the company you keep. Peer pressure can play a huge part in impulse spending and when you’re cutting back in order to get your debt under control, you’ll need people around you to be supportive and respectful of the compromises you may need to make in the short term. Frivolous friends can be very expensive!
- Make an appointment with your financial advisor. Be up front about your financial situation and have them help you develop a debt reduction plan that will structure your finances to reduce your credit balance as quickly as possible
When used strategically, debt can be an effective tool to help you progress financially. Too often however, bad debt becomes ugly and slowly eliminates a person’s financial security, sending them into a spiral of debt dependence. By taking responsibility for your credit commitments and taking simple steps to develop a debt reduction plan, you can reclaim your financial freedom and learn to make peace with your plastic!
If you’re facing a battle with bad debt and don’t know what to do next, our team are here to help. Contact us and let’s get working on your debt reduction plan today!
By Adam Marjoribanks