Back in the day, many Australians saw all debt as bad. Incurring debt was something that should only happen if absolutely necessary and it should always be paid off as quickly as possible.
But not all debt is created equal.
Managed properly, debt can help you purchase something you wouldn’t otherwise be able to afford. It can help you purchase something that has the potential to grow in value and generate income, allowing you to repay the cost of your debt – both interest and the principal – as well as build wealth. This kind of debt is ‘efficient’ and beneficial; that is, it can help you create wealth.
Then, there is inefficient debt. This kind of debt offers no financial advantages and often does financial harm over the longer term.
The key to using debt effectively is understanding the difference between the two.
Inefficient debt is generally from the purchase of assets that will depreciate in value, have no potential to produce income and do not offer any tax benefits. Examples include using a credit card or personal loan to pay for a holiday, wedding or other lifestyle expenses, and most car loans.
Financially, these purchases won’t benefit you at all – there are no tax deductions, and they typically don’t appreciate in value, nor will they provide you with a regular income. In this way, inefficient debt uses up money or borrowing power that could otherwise be available to help you generate wealth.
Even if you plan to invest the money you borrow wisely, debt can also be inefficient if it costs you more in interest or fees than it generates. Credit cards are a good example, as they typically carry a very high interest rate, much higher than many other forms of debt. The average credit card interest rate is around 16-17%, and it can be even higher for someone with poor credit.1 Personal loans, while generally less than credit cards, still tend to attract interest rates of around 6.5% to 10%, again depending on the lender and the borrower.2
If you consider what kind of return you would hope to make on an investment over the long term, it puts this number in perspective. According to the federal government’s Money Smart website, the average return over the last 10 years on property was 6.3% per year. Australian shares showed a similar return over 6.5% per year over the past decade.3
Based on these averages, it’s unlikely that your investment return would exceed the interest and fees you would pay on a credit card or personal loan, so you will most likely lose money over the long term.
Of course, credit cards and personal loans have their uses; sometimes you may want to purchase something for pleasure and at certain times in your life, a form of inefficient debt may be your only option. So long as you use inefficient debt only occasionally, and most importantly, pay off this debt very quickly, you should be able to limit most of the negative long-term financial impact.
Efficient debt, on the other hand, is used to purchase assets that are likely to appreciate in value. It should have a lower interest rate than you would reasonably expect to earn from your investment. Interest repayments may even be tax-deductible. Efficient debt is debt that you expect will help you generate wealth over the long term, so long as you have the financial means to pay it off over time.
Borrowing to invest, also known as gearing, can be an effective strategy to build wealth more quickly as it allows you to purchase more investments than you may otherwise be able to. It also allows you to generate a higher overall return – on both income and capital growth – if your investments increase in value over time.
Examples of efficient debt may be:
- buying a home, land or investment property
- investing in shares
- the cost of education if it will help you increase your personal income once completed
- investing in collectable items including wine, vintage items, artwork, stamps, precious stones or minerals (such as gold)
In assessing the efficiency of your debt, focus on the relative income and capital gain, rather than the amount of debt. If the income and/or capital gain from your purchase is greater than the cost of borrowing and the initial cost of your asset, you are most likely looking at efficient debt.
Of course, there is always the risk that an investment will decrease in value, and if you have borrowed to invest, you stand to lose more. You will also have the costs of borrowing to pay, such as interest and fees. Worst-case scenario, the lender could take ownership of your investment and you may lose more than your initial capital.
To mitigate this risk, use a financial adviser who understands your risk appetite, do your research and invest wisely, diversify your investments, stay within your financial means, plan to invest for the long term. and use a mortgage adviser who understands how to efficiently structure your debt.
SOURCES: 1https://SOURCES: 1https://www.premier.vic.gov.au/giving-business-tax-break-create-jobs, 2https://www.canstar.com.au/personal-loans/personal-loan-interest-rate-ranges, 3https://moneysmart.gov.au/how-to-invest/choose-your-investments