Do you know the difference between good debt and bad debt? You may believe your car loan is good debt, and your mortgage is bad due to the loan amount. However, good or bad debt is not determined by the loan amount.
A mortgage is ‘good debt’ as it is secured by an appreciating asset – i.e. an asset that goes up in value. Plus, when the mortgage is secured by an investment property that earns rental income, and the asset appreciates, it’s outstanding debt!
An example of bad debt is borrowing money with your credit card or personal loan to purchase a car, clothes, or other items where their value goes down (depreciates).
Did you know mortgages have much lower interest rates than credit cards and personal loans? Many borrowers don’t add up how much the loans cost them in fees and interest. Nor do they do their research when needing a loan. If the first lender offers the loan amount required to buy that fridge or boat, why not just take it? Well, the reason you don’t take the first offer is loan products have different terms and fees, including:
- Interest rate
- Loan term
- Credit rating
- Loan history
You may be paying more for it than what you can get from another lender by accepting the first loan offer. One of the main reasons borrowers with similar loans have different interest rates and fees is they have other lending risk profiles. The riskier a borrower is, the higher the interest rate for the loan. For example, an advertised personal loan interest rate may start from 6%; however, you can only get the loan for an interest rate of 18% if you’re deemed very high risk.
Paying too much interest and having too much debt can end in repayment defaults. Non-payment can then lead to legal action. What is a CCJ? If you need to know what a CCJ is – life is about to get quite tricky for you. A county court judgement is a legal action taken by a creditor to get a debt paid. Aim never to let your debt get out of control.
Freeing Yourself Of Bad Debt
To free yourself of bad debt, there are a few strategies you can use that are within your control, including:
- Loan Consolidation
- Increase Income
- Revise Budgets and Outgoings
If you have a home loan, there may be the opportunity to increase your loan amount to pay down your bad debts. Your mortgage lender will need to assess your repayments schedule and home value. If approved, you may have the option to increase your mortgage and use the extra funds to pay off your loans and credit cards.
There are also loan consolidation products where lenders will offer an attractive loan rate, and you can pay off all your bad debt and then focus on paying off the one consolidation loan within a fixed timeframe, e.g. five years.
What is a Trust Deed? If you are looking to lower the amount of interest you pay on credit cards and other forms of debt, a trust deed may be a great option. Trust deeds can enable you to lower your interest rate by 0.5% or more, depending on the terms of the trust deed. A trust deed is a loan secured by a property. It is possible to use a trust deed to pay off debt, refinance your mortgage, or make home improvements. The key is to make sure that your property is worth more than your total debt so that you can avoid foreclosure.
Another way to take care of your debt repayments is the avalanche strategy which requires:
- A list of all your debts (student loans, auto loans, credit card debts etc)
- Arrange them in order of highest debt to the lowest debt
- Start paying off the debts in this specific order
Be mindful to pay the minimum repayments for all loans. The avalanche strategy is where you’d put your extra savings to pay down the most costly debt first.
Pay off bad debt as soon as possible so your money can make money.
Increase Your Earnings
Your salary is the most crucial asset-building tool that you have. When you work on paying off your debts, you empower your pay to be utilised for a higher fulfilling purpose. You can divert your left-over salary into investments rather than using it to take care of bills. Fixed income occupations can be limiting when you need to increase your earnings, so there are other strategies available, including:
- Create a side hustle
- Take on a part-time job
- Invest in property
How frequently do you hear your friends say, “I hate this job!” The salary is mostly the primary motivation when it comes down to quitting or staying at your job. However, if you like your job and career, look at other strategies to increase your earning potential. Also, consider upskilling so you can earn more doing the job you love. Education and training will make you more attractive on the job market, and employers will pay what they need to get you on their team.
Revise Budgets and Spending
You’ll know you are serious about getting rid of bad debt when you cut out discretionary spending, i.e. items and services you do not need – want.
Create a budget that cuts your spending and allows you a day a week for one luxury item. For example, go to a cafe with a friend or buy something small for yourself.
When you work out a budget and see the extra money you have to pay back bad debt earlier, you can celebrate and have peace of mind that you have your debt repayment plan under your control.
Always get professional advice before choosing loans and investments.
There is such a thing as good and bad debt. When you leverage your investment with a loan like a mortgage your money is earning money. The investment should earn an income and ideally reward you with more capital when it’s time to sell. Keep your bad debts down so you have more disposable income for investing in assets like property.