What’s the difference between good debt and bad debt?

Answer

Debt is considered good when it’s efficient—that is, it’s working to help you build wealth. Bad debt is categorised as inefficient because it generally costs money (interest charges) without helping to build long-term wealth.

Good debt is often used to help build long-term wealth and makes financial sense: you’re better off with it than without it.

One of the most efficient ways to use debt can be borrowing to invest in an asset—such as property or shares—which can generate income and grow in value while the interest charged on the debt is tax deductible.

The least efficient debt is money borrowed through credit cards and personal loans to pay for day-to-day expenses or an asset—such as a car—that decreases in value.

Some may argue that even your home loan can be considered inefficient debt when compared to an investment loan. Because while your home is likely to increase in value, it will generally not generate an income and the loan interest charges are not tax deductible. On the flip side, when you sell your home, it will not be subject to the capital gains tax imposed on an investment.

When it comes to making the most of good debt, a debt recycling strategy has the potential to help. Debt recycling can be a high risk strategy—it doesn’t suit everyone—that allows you to use good debt to repay bad or inefficient debt more quickly.

Good debt still presents risks and can be used to buy assets that have the potential to grow in value and generate an income—potentially benefitting you with:

  • income to help repay bad debt (and the loan used to fund the good debt)
  • tax-deductible interest charges.

 

Important information

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