The Anatomy of Debt

February 28th 2024 | Categories: Debt Management | | Tags: debt |

Exploring the most common types of household debt.

Not all debts are created equal, a lesson for many that is unfortunately learned before it is taught. How well do you understand the consequences that borrowed money can have on your financial future? Equally when debt can be beneficial and support your long-term financial goals. The distinction between often debated ‘good’ and ‘bad’ debt lies not in the amount, but in what it’s invested in.  

From a financial advice perspective, we see good debt as one that supports your goals and grows in wealth, while bad debt depreciates in value and costs you money. 

Home Loans:

A home loan, though initially daunting as a major investment, is generally considered a good debt. Investing in real estate has the potential to pay off in the long run as property values tend to rise over time. Additionally, if the property is an investment, rental income from tenants can contribute to your overall financial well-being. 

The risks associated with having a mortgage are overextending your borrowing capacity. As we’ve seen in recent times with historic interest rate rise, this can lead to high mortgage repayments ultimately leading to financial stress. Building equity in a home is the goal, making the investment worthwhile in the grand scheme. 

Student Loans:

Education is a privileged investment, and student loans, such as HECS-HELP debt, can be instrumental in securing a better future. Your career is arguably the biggest asset you will possess throughout your lifetime, and enhancing your education can lead to role progression and increased earning potential. Government-provided student loans often offer favorable terms, making them a comparatively sensible choice for investment in your future. 

While student debt is considered interest-free, it is subject to CPI loading every financial year with CPI for 2023 FY which was 4.1% last year. You can read more on the good and bad of student debt here. 

Startup Costs:

Do you dream of being your own boss? Starting a business often requires a significant upfront investment. While all investments carry risk, borrowing money for startup costs can put you ahead if carefully evaluated. Entrepreneurship can yield long-term dividends, provided risks are thoroughly assessed. 

Consumer Debt:

Funding a lifestyle through consumer debt is a common pitfall. Using credit cards for non-appreciating expenses like clothes, dining out, or entertainment can lead to a cycle of accumulating interest and falling deeper into debt. Short-term loans and buy-now-pay-later (Afterpay, Klarna, Zip Pay, the list goes on) schemes may seem convenient but can result in hefty late fees if repayments are not made on time. 

Car Loans:

While having a car is often necessary in transporting you from A to B, taking out a hefty loan for a rapidly depreciating asset is generally considered a bad investment. Careful consideration is needed to ensure the car purchase aligns with your budget, avoiding excessive borrowing that may strain your financial situation or affect your future borrowing power.  

How to effectively manage your debts:

As a guiding principle, if your savings can’t afford something now, consider delaying the purchase until you have accumulated enough to cover the costs. Ask yourself if the item being financed will grow in value, increase your wealth, or significantly enhance your well-being. If not, it’s likely a purchase that can wait until you’re in a more financially secure position. 

Debt is a financial tool that can shape your opportunities. While a good investment can pave the way for wealth-building, accumulating ‘bad’ debt can hinder your financial growth.  

Top tips –  

• Get clarity on a realistic budget and what you can afford to spend each month 
• Track your spending  
• Know where your dollar goes 
• If you’re spending more than necessary, reduce the limit on your card. 
• Review your current interest rates and compare for a better option 
• Focus on paying down the loan with the highest interest rate first 
• Consider Refinancing 
• Consider leveraging home equity 

In a world driven by instant gratification, embracing delayed indulgence and making informed financial decisions is crucial. Always borrow money wisely, conduct thorough research, and remember that not all debts are created equally. Choose financial paths that align with your long-term goals and navigate the world of debt with prudence for a secure financial future.  

You may also be interested in our articles:

• Retiring with debt? You’re not alone
• Ask an Adviser – What is Debt Recycling?
• Debt Recycling. How does it work, and can it help you get ahead?
• How to manage debt when approaching or in retirement

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