Q&A: What's the difference between good and bad debt?
Written and accurate as at: Aug 08, 2022 Current Stats & Facts
I have surplus cash every month and want to pay off some debts. Which debts are considered good and which debts are considered bad?
Getting debt under control can feel empowering. And, as you’ve pointed out, not all debts are considered ‘bad’. Some debts can be needed to help you get ahead in life, achieve your goals, and help you build wealth. Generally, these are known as good debts. Your home loan falls within this category given the purpose behind it, and the long-term likelihood of your home increasing in value.
Often good debt also encompasses circumstances where debt is used to invest in an asset which might provide income (and/or capital growth) over time. This kind of debt is often referred to as investment debt and includes, for example, borrowing to invest in property, shares, or a business. In some cases, the interest paid on these debts is tax deductible, potentially reducing your personal income tax bill and saving you money.
Bad debts, on the other hand, usually take you away from your long term goals, and in most cases, involve the purchase of things that decrease in value the moment you buy them, for example new clothes, a new TV or car. In addition, they may also negatively influence your spending behaviour (eg the purchase of certain products and services, as well as the frequency and amount paid for these products and services). These debts also often have a higher rate of interest payable. Examples of bad debts can include credit cards, personal loans, and ‘buy now, pay later’ services.
A rule of thumb for prioritising debts
There is no hard and fast rule for repaying debts, however one general principle that can provide some direction, is to tackle bad debts first:
- Bad debts: Generally, it makes sense to pay off bad debts first, such as credit card debt, car or personal loans. Doing this may eliminate the debts with the highest rate of interest without losing any tax benefits, because these debts aren’t generally tax deductible.
- Home loan: Once bad debts are dealt with, depending on the circumstances, it can make sense to consider mortgage repayment next. Even though a home loan is considered a good debt, the interest payments aren’t generally tax deductible.
- Tax-deductible debts: Leaving tax-deductible (or investment debt) until last means that , depending on the debt, there may be some tax benefits while the other debts are being paid off.
As mentioned above, this is just a general rule of thumb. The right approach for you all depends on your personal circumstances and goals. Seeking qualified and professional advice in this area can be an important consideration.
Deciding on a debt repayment strategy
If you have more than one bad debt you want to see the back of sooner rather than later, an effective debt repayment strategy can help you stay focused on your goal. Here are two common debt repayment strategies that may be worth considering:
The snowball method: This approach involves paying the smallest debt off as quickly as possible, and making the minimum repayments on all other debt. Once the smallest debt has been paid off, the surplus money is then directed towards the next smallest debt, and so on. Your repayments gradually snowball as you repay each debt and free up more money. Tackling small debts first can work well if you like the idea of quick wins to keep you motivated.
The debt avalanche: This approach involves paying off the biggest debt, or debt with the highest interest rate, as fast as possible, and making the minimum repayments on all other debt. Once the first debt is paid off, the repayment money from the first debt is then directed towards the next largest debt, or debt with the next highest interest rate. And so on.
This approach can work well because it eliminates larger interest payments first, potentially saving you more money. Eliminating a large debt can also provide a big confidence boost and help you feel in more control of your finances.
Final thoughts on debt repayment
Like all money matters, the most appropriate way forward really comes down to your personal circumstances and financial goals. Having multiple debts hanging over you is often not a great feeling. But at the end of the day, it’s about finding what works for you, and sticking to it. Once you decide on your repayment strategy and get into a rhythm, you may find yourself rid of your bad debts sooner than expected.