We are all taught that we should aim to reduce our debt levels and some of us are better at it than others. There are however a number of strategies to reduce debt effectively and in some instances holding debt can make sense as a wealth creation strategy.

There are effectively three types of debt, good debt, bad debt and very bad debt. So what is the difference?

Good debt is generally debt that attracts a tax deduction because it has been used for a tax deductible purpose such as acquiring an income producing asset such as a rental property or shares. If you are on the top marginal tax rate the tax deduction will, in effect, halve the interest rate. In our current low interest rate environment that may not sound like much but it has a dramatic effect over the longer term.

Bad debt is really any other form of borrowing that does not attract tax relief. The exception is very bad debt, namely credit cards. With interest rates anywhere between 15 per cent and 20 per cent, they will slug you three to four times the typical home loan rate.

It is very difficult to argue against placing a strong priority on repaying personal loans or credit cards that have been used to fund lifestyle choices. At an interest cost of more than 15 per cent it would be unlikely that money could be used elsewhere to provide a higher return rather than reducing the high cost of this debt.

One effective strategy is to move very bad debt to bad debt. This is available where you have equity in your home and simply involves borrowing against your home at a cheaper interest rate to repay the very bad debt.

Another strategy that is available is the conversion of very bad or bad debt to good debt. A common way of achieving this is to use existing assets. For example you may own a number of shares from various floats such as Telstra. These can be sold to repay bad or very bad debt.

A new “good debt” loan can be obtained and used to repurchase assets equivalent to the value of shares sold. This will, in effect, mean you have the same value of investable assets but your debt mix has changed. Transaction costs and capital gains tax will of course need to be considered.

Many people establish a “good debt” line of credit secured by their home but split from their “bad debt” mortgage to facilitate these arrangements. In this way your overall cash flow will improve as the after-tax costs of your “good debt” will be lower, enabling you to channel further funds into reducing your “bad debt” home loan.

Careful management of your borrowings can result in very significant savings that will compound over a long period of time. Savvy wealth creators are disciplined and work hard to reduce non tax deductible debt as quickly as possible while building a tax deductible line of credit.

Posted by Allan McKeown Money Manager (Fairfax Digital) on 29th October, 2014