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In a time of low interest rates, we can be swept up by the notion that we need to pay all of our debt down as quickly as we can. Particularly if we’ve just bought a property and have the big mortgage to go with it, or we’re about to go spring property shopping and buy an investment property.

But what if I was to suggest to you that paying all your debts down at once is not as smart as you think? As Australians particularly, we’ve been taught that all debt is bad and you need to get rid of it as quickly as you can.

However, it’s important to understand the different types of debt you have because while some debt might in fact be bad debt, some debt is actually good debt.

It’s a strange concept I know, but stay with me while I explain. Let’s say you have a mortgage on your home of $300,000, an investment property loan of $400,000, credit card debt of $10,000, a HELP loan of $15,000 and a car loan of $25,000.

Most people would generally be making at least the minimum principal and interest payments on all of these loans which means each individual debt is gradually reducing each year.

Now that might seem like a reasonable solution to gradually paying down all of the loans. However, when we understand the difference between good debt and bad debt we can make strategic decisions around what should be paid down faster and perhaps what debt shouldn’t be paid down at all. I know that might be an odd concept but it’s one that can save you potentially tens of thousands of dollars in the long run.

So if you’re off to buy a property in the spring sales and will end up with a mortgage or an investment loan, how do you know if it’s good debt or bad debt? What debt should you be paying down and what should you be paying interest only on or maybe even making no repayments at all?

Bad Debt

Bad debt is generally any type of debt that you won’t receive a tax deduction for. So in the example above it would be the mortgage of $300,000, the credit card debt of $10,000, the HELP loan of $15,000 and potentially the car loan of $25,000.

Of course, just because all the debts are bad debts doesn’t mean they’re all equally bad. It’s important to look at all of your bad debts and work out which ones should receive the most attention in the form of extra repayments rather than just paying them down at the same rate with maybe a little more added to your home loan.

How you determine which is bad debt and which is worse debt is by looking at the loans themselves. So for example the mortgage of $300,000 might seem the scariest because it’s the biggest but if it’s at an interest rate of 5 per cent and your credit card debt of $10,000 is at an interest rate of 15 per cent then it makes sense to pay the credit card debt off first.

Similarly, HELP debts generally only increase with CPI, so while this is low, it makes more sense to pay off the credit card, car loan and mortgage first than make additional repayments here only once they’re gone.

OK Debt

If the car loan of $25,000 was for a certain type of ute you’re using for work or you’ve kept a log book on the car and can prove business use, then this loan may convert from bad debt to OK debt. Now I call this OK debt and not good debt because it’s still for an asset that is going to depreciate in value so you still want to pay it off even if you do receive a tax deduction for it.

However, if you have a mortgage, credit-card debt and other loans then it would make more sense to make additional repayments to your bad debt first rather than making additional repayments to your OK debt.

In some cases, your mortgage might fall in the OK debt category, particularly if you’re going to retire in a few years’ time and you’re still working. That’s because with the current low interest rates, it may make more sense for you to make the maximum contribution to superannuation and receive a tax break then it would to be making extra contributions to your home loan. Of course, once you retire you can then withdraw these extra super contributions in a lump sum and dump them straight on to your home loan.

Good Debt

Investment loans almost always fall into the category of good debt which in our example is the investment property loan of $400,000. Some people may want to pay this loan down first because it is the biggest loan and psychologically the scariest one. However, the interest on this loan is a tax deduction which means it’s effectively cheaper than your home loan.

If you still have bad debts then it almost always makes sense to convert good debts like investment loans to interest-only to maximise any interest claim you can make. This might seem strange to not want to pay down a loan – of course you want to reduce your debt, right?

However, this strategy only makes sense if you take the extra money you saved by switching to interest-only and putting them towards your bad debt. That way the entire debt amount is still reducing, but you are maximising any tax advantages you might have.

It might seem like a strange concept to think of debt in terms of good and bad when we’re conditioned to think of all debt as bad. However, by being strategic with your debt you can ultimately ensure that your entire debt disappears faster, simply by choosing the rate at which your individual loans are paid off – and that’s always a good thing. Melissa Browne is an accountant, adviser, author and shoe addict.


Posted by Melissa Browne – The Age on 25th August, 2015