Not all debt is the devil. There are actually three kinds of debt: “dumb”; “okay”; and “great” debt. To categorise them, you need to ask two questions.
One: Will the purchase increase in value? Two: Is the interest tax deductible?
Dumb debt answers “no” to both. These assets fall in value and the interest is NOT tax deductible. For example, stuff you put on credit cards, cars, furniture, electrical goods, etc.
Okay debt is either generally going to appreciate in value, or be a tax deduction. For example, your home is likely to increase in value, but it isn’t a tax deduction. Work cars are “same, same, but different”. If your car is a business expense, then it qualifies as a tax deduction, but it is falling in value.
Then there’s “great” debt, which answers two yeses. Appreciating assets with tax deductibility? What is this magical debt? Investment debt, predominantly shares and property.
With the single-mindedness of a Dalek, you should “EX-TER-MI-NATE” dumb debt. Pay off the highest interest rate rubbish first.
Next comes okay debt. If you’re dumb-debt free, turn your excess cashflow towards your home loan.
And great debt can be a powerful wealth creation strategy, particularly for Gen Xers. It often makes sense to pay interest only.
But the biggest mistake I see regularly is by those with $10,000 in savings and $10,000 on the credit card. They’re paying $1800 a year interest on the card and earning $500 a year on their savings, which becomes about $330 after tax. They are literally throwing away nearly $1500 a year, or $30 a week. That’s a lot of beer money!
Bruce Brammall is the author of Debt Man Walking (www.debtman.com.au) and principal adviser with Castellan Financial Consulting.