When you hear the word debt, what goes through your mind? Are all your images of debt bad? Debt isn’t bad as long as you can afford it.  In fact, most Australians wouldn’t be able to own a home without getting a loan. Loans and credit cards can be very effective tools to help you achieve what you want in life.

There are many types of debt.  Such as:

• Home Loans

• Car loans

• Credit cards

• Consumer leases

• Interest-free deals

• No or low interest loans

• Overdrafts

• Personal Loans, and

• Payday loans

Different forms of debt have different interest rates, fees and conditions, including the length of time you have to pay off the debt (this is known as the ‘term’ of the loan).

Good vs Bad Debt

It is inevitable that most Australians will take on debt at some point during their lifetime. It could be to fund education; a personal loan to buy a new car or cover holiday expenses, or take out a mortgage for a home or investment property. But to be able to achieve financial independence it is vital to understand the difference between good debt and bad debt.

Good debt is usually an investment that will increase in value over time and will help build your personal wealth or provide you with long-term income.

Bad debt, on the other hand, will decrease in value quickly and will not add to your personal wealth or generate a long-term return.

Some examples of good debt include:

Property

Historically, property values have consistently increased over time, making owning your own home or investment property a good debt. With low interest rates and a longer time to pay off the loan, typically 25 – 30 years, one can expect the value of the house to double or even triple during the term of their mortgage.

Shares

Borrowing to invest in publicly listed Australian blue chip shares is usually considered good debt too. Investing in shares can boost your wealth over time with the potential to earn much more than a bank term deposit.

Education

Investing in your education, whether a University degree or technical skills for a trade will enhance your skill set and increase your ability to earn a higher income in the future. That makes it a solid investment in your future.

Small Business

With a solid idea and a realistic business plan, borrowing money to get your own business off the ground can be a good debt, paying you rich dividends as the business grows.

Some examples of bad debt include:

Credit cards

It’s easy to swipe and pay with plastic and lose track of how much you’re actually spending. If you can’t manage to pay off your credit card balance in full every month you start paying high interest on the debt you accumulate, so beware.

Car and consumer goods

Taking out loans to buy a car or buy the latest flat-screen TV are examples of bad debt. You end up paying interest on things that depreciate in value quickly.

Borrowing to repay debt

If you are struggling to pay your debt, then borrowing to repay your debt could get you into deeper trouble. Interest rates may be higher and you may just find yourself further in debt.

Borrowing to fund a holiday

Personal loans taken to fund a holiday could leave you with a gaping financial hole to deal with once you’re back from your holidays.

Regardless of whether it is good or bad, it is prudent not to incur more debt than you can comfortably afford to pay back.

Eliminating bad debt should be a priority when aiming to achieve financial independence. Before taking out debt, make sure you have a clear and realistic plan for paying it back, through a series of regular and affordable payments.

Work out if you can afford to borrow

If you're thinking about borrowing money, ask yourself the following questions.

What am I borrowing money for?

Is it for something you need, or something you want? Are you borrowing money to help someone else?  Or do you need credit to pay electricity and other bills?

Is borrowing my best option?

There may be other ways to get what you want without borrowing money. For example, you can save and buy the item outright, or put it on lay-by and gradually pay it off. If you are on a low income, you may qualify for a no or low-interest loan.

Have I checked my credit health?

Have you got a free copy of your credit report? Credit providers use your credit score and report to assess your capacity to repay a new loan, credit card, or mobile phone plan, or if you seek to increase your limit on an existing credit card.

A poor credit report could affect any loans or credit you apply for in the future, so it is important to make sure the information is correct.

Can I afford the repayments?

Work out your current spending and how much you can afford in repayments.

Allow for interest rate rises, unexpected expenses and financial emergencies. Before you borrow, try living on less for a few months to see if you can afford the loan.

Is now the right time to borrow?

Think about any changes that might affect your income. How secure is your job? Are you planning to start a family or take time off for study? Do you have any health issues that may mean you'll earn less for a while? If you said 'yes' to any of these questions, you might be better off saving now and borrowing later.

Debt Tips

Borrow within your means at the start

The key figure is not how much you owe or how much you can borrow, but how much you can afford to repay.

If you haven’t done your budget, you don’t know how much you can afford to repay.

So start by putting together an accurate budget listing all income and expenses. As a general rule of thumb, Claire Mackay recommends 40 per cent of your money should be going towards housing costs (if you own your own home), 30 per cent to living and 30 per cent to saving for the future.

Take control of your spending

Australia has run a consistent budget deficit since the global financial crisis of 2008, which means as a nation we’re spending more than we’re earning (and using debt to keep the lights on).

So take a lesson from all those pollies in Canberra: don’t be like them.

Armed with your new budget, work out whether you’re in deficit or surplus. If you are in a deficit, look at what to cut to get back to the black.

The pie is what the pie is. What you can control is what you think of as essential living expenses and what you consider as nice to have.

Make extra repayments

Funnelling extra money into paying debts off early will save you big on interest and free up money to put towards building your wealth.

Start with the highest interest rate debts fist, because they are costing you the most.

For example, the average Australian credit card debt is $4,315. At an average interest rate of between 15—20 per cent that’s a guaranteed return of around $700 a year in saved interest … just by paying off your card.

Once your credit card is paid off in full, you can focus efforts into the next highest interest rate loan, for example a car loan.

Minimise the interest you pay

In a low interest rate environment, there are always opportunities to minimise the interest you pay, and that money is always better off in your pocket than the bank’s.

Compare the market for the best rate. Don’t be afraid to negotiate with your bank or switch to a better provider if the terms stack up.

And look for product features that can help you save on interest, like mortgage-offset accounts or credit card balance transfers.

As treasurer, if you can borrow within your means, control your spending and minimise bad debts and interest, you are managing debt effectively … certainly better than the mob in Canberra!