Money

The four types of debt

Paul Clitheroe.
Paul Clitheroe.

THE Reserve Bank may have handed home owners an interest rate reprieve at its May Board meeting but plenty of tipsters are suggesting that rates could start to climb later in 2011.  At times like these, when the rate outlook is uncertain, it pays to remember that not all debt is bad. The trick is to manage your debt wisely.  

A sensible rule of thumb is to avoid using debt where possible and pay for purchases with cash instead. But there are times when debt is essential to buy the things we need.  

Debts like our home loan are what I call ‘happily necessary’ debt. I’m comfortable with this type of debt because it is used to pay for an asset that should grow in value over time. Nonetheless mortgage repayments are a drain on our financial resources, so you should plan to own your home debt-free as soon as possible and the best way to do this is by making extra repayments.   

Another useful type of debt is what I term ‘effective’ debt. This is the sort of debt used to invest in an asset that will generate long term capital growth and possibly ongoing income. Loans used to pay for a rental property, shares or a small business are examples of effective debt.  

The interest paid on effective debt is generally tax deductible, and this greatly reduces the cost of the loan. With this type of debt it’s critical to only take on what you can comfortably afford to repay – even if the underlying investment experience periods of low returns or even losses.  

A third type of debt is what I think of as ‘sadly necessary’ debt, and it’s the type used to buy essential purchases like a car. Cars depreciate rapidly, making them a terrible investment but we need them for day to day living. So don’t feel too guilty about sadly necessary debt as almost all of us have had it at some stage, but do aim to pay it off as fast as possible and be sure to shop around for the best rate.  

The fourth type of debt is ‘disastrous’ debt, and by this I mean things like a credit card that’s maxed out with nice-but-not necessary purchases like a new TV, the latest furnishings or a spending hangover from an overseas holiday.   The best cure for disastrous debt is shock treatment. Focus on your budget and cut spending to the bone until high-interest loans or credit cards are paid off. If you’re struggling financially, get in touch with lenders to renegotiate a manageable repayment plan – and do it before you miss a payment.  

If you take a moment to categorise your debt, chances are the bulk of your repayments are going towards ‘good’, ‘effective’ or ‘sadly necessary’ debt. It’s disastrous debt that can pose the greatest risk to your financial well-being and aiming to keep this type of debt to a minimum will offer some protection from possible future rate rises.    Avoiding disastrous debt also means you won’t pay more than necessary for purchases with the addition of interest charges.  

Paul Clitheroe is a founding director of financial planning firm ipac, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.

Topics:  clitheroe, debt, rba


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