The difference between good and bad debt
I get asked about this all.the.time. What is good debt, and what is bad debt? Isn’t all debt bad?
Debt is debt. It means you owe someone (usually a bank or alike) some money. At some stage in the future you are going to need to pay it all back, so whether the debt is considered ‘good’ or ‘bad’ doesn’t really matter when it comes to whether you owe someone or not.
So, what is the difference?
Good debt is usually considered debt that you can get a tax deduction for. So, any debt that you have that is for the purpose of making money, you can usually claim a tax deduction on the debt. Now there are couple of things to note with this: firstly, the tax deduction that you receive is only on the interest that you pay on the loan and some of the lending expenses, not the principal and interest. So, if you have an investment property, you are able to claim a tax deduction on the interest portion of the repayments only.
Now, remember, a tax deduction doesn’t mean you get the whole lump sum back (that is a tax offset), a deduction means that it reduces the amount of income that you earned (on paper) through the year, so when they calculate the tax you need to pay, it is based on a lower income. The benefit of that, is that you end up paying less tax to the tax man.
Examples of ‘good debt’ are business loans, investment loans, car loans that fund a car for your business, and anything that is in place for the purpose of making a profit.
Bad debt is just your regular every day debt. I am talking home loans for the house that you live in, credit cards, personal loans, and personal car loans. You cannot claim any tax deductions on these, because they are for personal use and not for the purpose of making money.
Why do you need to know the distinction?
Like I said a debt is a debt, you are still going to need to pay it back as some stage. If however you have a good debt (tax deductable debt) and a bad debt (your home loan), then you are better off paying the ‘bad debt’ off the quickest. Whatever excess cash you have should be thrown into your home loan to pay that down quicker.
That’s it. Nothing too complex, but hopefully that explains what this whole thing is about. It’s important to understand that this doesn’t have anything to do with negative and positively gearing something, I’ll get into that in another post. The distinction is just between whether you can claim the interest repayments as a tax deduction or not.
As always, any questions let me know!
The post is from our resident Financial Planner Cara Brett, check out her details in the About Us section.