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Good Debt versus Bad Debt

One of the major road blocks to building wealth for the future is carrying too much debt…or more specifically, carrying too much bad debt.

Many advisers and accountants have varying opinions as to what is good debt and bad debt. For instance many say good debt is tax deductible debt and bad debt is non-tax deductible debt. I don’t necessarily agree with this. By this definition a loan on every investment property would be good debt. But what if the property purchased was a rubbish property – such as a small apartment in a high rise apartment building that the “investor” paid too much for and is never going to grow in value? The loan may be tax deductible…so called “good debt”, but the property may not be worth any more in 10 years time than what it is now. I certainly wouldn’t consider this to be good debt…let alone a good investment.

On the flip side of this, I wouldn’t consider debt that has been used to buy a decent home in a good area to be “bad debt”. Sure it may not be tax deductible…but this asset is likely to be a foundation of your wealth creation plans as you strive to fuel your family’s future. This is of course providing that you haven’t tried to keep up with the Jones’ – or your best friends – and bought a house you can’t afford resulting in no cash flow being available to fund your wealth creation journey…it all comes back to cash flow.

My personal definition of good debt and bad debt is “good debt helps you build long term wealth (provided it’s affordable) – while bad debt erodes your ability to build wealth”.

By this definition tax deductible debt on a rubbish investment property is bad debtas is the personal debt that is the biggest contributor to Generation X & Y not being in a position to build wealth…credit card debt. The purchases that these personal debts are used for might make us feel good in the short term…but just like too much ice cream on a regular basis – they are terrible for us in the long term. (If you currently have credit card debt issues, see my blog Wealth Creation for Gen X – How to best smash your credit card debt…forever!).

As I will cover further in future blogs, taking on debt is an important part of Gen X & Gen building wealth for the future. But it needs to be good debt, not bad debt. In my mind good debt is essentially debt that is used to buy good quality assets that are likely to grow strongly over time – whether this be your home, a quality investment property in a good location, a diversified mix of blue chip shares, or even a business.

However I do think it’s crucial to be building wealth and reducing debt in tandem with one another…even if you currently have a high maxed out credit card debt. Saving money and building wealth feels good mentally and emotionally. Being solely focused on reducing bad debt doesn’t feel good. Importantly, saving money creates momentum as well as good habits.

The same applies to those Gen Xer’s who might be in a good cash flow position and be focused on reducing their home mortgage. If this is you then you might ask, “why shouldn’t I keep doing this?”. The challenge with this is that you need to live somewhere and your home won’t produce you an income in the future. I’m a big advocate for reducing your home mortgage because once again it feels good…and it’s a risk free return. But as we’ll cover next week, it’s important to be doing this is tandem with an appropriate wealth creation strategy to build multiple income streams in order to create future financial freedom.

What debt are you carrying at the moment?…Is it good debt or bad debt?

Matthew Morrison is the Director of Wealth Advisory at The Practice, a Personal Wealth Advisory & Business Advisory firm based in Parkville, Melbourne. Matt along with The Practice team are committed to and passionate about developing & implementing wealth creation strategies for clients to enable them to Fuel their Family’s Future (while protecting them along the journey).

Matt and The Practice team can be contacted via http://thepractice.com.au or (03) 8888 4000.

Disclaimer – the above views are general advice only and are purely the opinions of the author. It’s important that you seek personal advice & guidance based on your individual circumstances.