Effective debt management is not just about the interest you pay, but also the type of assets you’re investing in and prioritising your debts. There are two basic types of debt we use in our everyday lives: Inefficient debt and Efficient debt
Inefficient Debt and Efficient Debt
Inefficient debt, or bad debt, is used to buy goods, services, and assets that do not generate any income at all. What it means is that you need to rely on your own sources of income as well as assets in order to repay this type of debt. Another disadvantage is that the interest cost of inefficient debt is not tax-deductible. Inefficient debt can likewise impact your other wealth-building opportunities. The best course of action is to reduce inefficient debt as soon as you can. You can do that by repaying those with the highest interest rates first. This can be done in a number of ways like consolidating your debts into the loan with the lowest interest rate. Examples of inefficient debt include credit loans, home loans, and personal loans.
Efficient debt, or good debt, on the other hand, is used to buy assets that have the potential to grow in value and eventually generate an income for you. They can benefit you in two ways. First. the income from the asset can be used to help repay the loan. And second, the interest cost may be tax-deductible and this helps minimise any tax. Smart debt managers would often use this type of loan to help build long-term wealth. Examples of this can range from investment property loans and investment loans to business loans.
Borrowing to Invest
Borrowing to invest (also called gearing) allows you to invest in assets you wouldn’t otherwise have been able to. It can help spread your money across different investment types, which can help reduce risk. This greater exposure gives you the potential to magnify your returns, but can also magnify your losses. If you have built up equity in your home or investment portfolio, you may be able to borrow against this equity.
Others take out special investment loans – often called margin loans. You can also borrow a lump sum with regular amounts to add to your investment – known as instalment gearing. Since the interest costs are usually tax-deductible, gearing can be a tax-effective strategy. With margin loans, lenders allow a maximum gearing level known as the debt to asset ratio (or loan to value ratio – LVR). If markets fall and the value of your investment drops, a margin lender may make a margin call, requiring you to put up more money at short notice to restore the LVR. You might have to offer more security or even sell some of your asset holdings at current prices to bring your gearing down to the right level.
Retirees should consider how comfortable they are taking on more debt or focusing on eliminating their debt. Margin loans should only be considered by investors who are comfortable with an above-average level of risk. As any investment professional will explain, an opportunity should not be considered for its tax effectiveness. It needs to be measured by how strong the underlying asset is, and its potential for growth. Tax-effectiveness is a method that helps improve investment viability – it should not drive the decision.
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