Debt can be a bit of a scary word, but don’t worry, this is a safe space! This article covers what it is, how it affects your mortgage application and how to best manage your debt.
The definition of good debt is one that will generate long-term income or grow in value.
The obvious example of good debt is borrowing to purchase assets such as a property or a business. Property will most likely grow in value over the long term and has the potential to generate income, as does a business.
Student loans can also be included in the good debt category as the assumption is the degree you earned will positively affect your future income. Likewise, borrowing to purchase tools of your trade (i.e. a ute for a builder or a laptop for a copywriter) is an investment to enable future income. However don’t fall into the trap of trying to justify a want rather than a need – borrowing to get the newest model ute isn’t likely to be a necessary or wise move, nor does new shoes for a job interview count as an investment.
Bottom line, if you’ve thought it through, done the numbers and decided the debt is a good or necessary investment then don’t lose sleep over signing the loan papers.
The bad debt is sadly all the fun stuff. We’re talking the credit card debt racked up on nights out, new outfits or the latest xbox. The holiday paid for with a finance company loan.
On TV, online, in print, radio, everywhere you look there are ads from credit card and finance companies. They bombard you with the message that you should go ahead and splurge on the new bag, the bike, the holiday. Nevermind if you don’t have the money, they’ll help you out! Ultimately though, you end up paying a lot more than the item is worth thanks to the interest payments and your ability to both save for a deposit and get approved for a mortgage is affected. If you’re reading this and screaming “It’s too late, I’m $5,000 in the hole thanks to a late night impulse purchase of a variegated monstera deliciosa off TradeMe!!” Take a calming breath and read on, we have tips for getting back on track.
Here we leave the nice clear lines of “good” and “bad” and enter the murky grey.
Car loans are very much in this area. Ideally you should only buy a car you can pay for with cash. However, if that means getting a car that needs expensive repairs for WOFs or a car that breaks down then it can cost you more in the long run than a loan would have. Vehicle safety is also understandably important to many. For these reasons a car loan may be the best choice in some circumstances.
Generally speaking, microfinance companies are awful. They’re predatory and can quickly get people into a hole of debt that is impossible to climb out of. We’ve all seen the billboards advertising loans at 8% per week. But, believe it or not, they originally had a positive purpose.
Consider a very simple situation of someone needing to buy a chisel to start a sculpting business. The chisel costs $10 but this client doesn’t have any money and the bank isn’t interested in lending to them. If they have a chisel, they can make a sculpture a day that will make them $2 profit.
Is 8% per week a bad debt in this circumstance? An argument could be made that the interest rate is still predatory but it has allowed someone to make enough money to make a good profit and gives them an ongoing income.
From that angle, microfinance (the service of very small loans to produce income) has a function in the world. There is almost no call for it in NZ but the point to take away here is that even bad debt can be good debt in the right circumstances.
When considering your application for a mortgage the bank looks at your current debt and correspondingly decreases your projected income. If you’re earning $100,000 a year but are paying $1,000 each month in interest and loan repayments, the bank will put your income at $88,000. This makes sense, however the below may come as a surprise.
Banks assume payments go on in perpetuity. So even if you’re only a few months away from paying off your car loan the bank doesn’t take that into consideration. Instead they calculate your projected income on the assumption that your fortnightly car loan repayments will continue indefinitely. For this reason if you are close to paying off a debt and are able to do so without dropping your deposit below your minimum, it can be worth paying off the debt sooner rather than later.
Student loans are treated slightly differently to other forms of debt. The banks would care if you had $100,000 of credit card debt, but aren't worried about your $100,000 student loan. This is because your student loan payments will always be set at 12% of your income. The government can’t call your loan in and it's interest-free, as long as you stay in the country.
With your credit card it’s the limit that counts, not how much you currently owe. The bank will calculate your income with the assumption that you are going to max out your credit card. This means reducing your credit card limit will increase your projected income. For further information see our article How much does a credit card affect your lending?
The bank will also check your credit score and your credit history for the last three months. Before applying for a mortgage make sure you have paid all debts on time over the previous three months.
Your credit score is a rating given to you out of 1,000 and indicates to lenders how reliable you have been in managing your debt. Your score is based on your credit history and gives lenders a way to measure your reliability with lending. A score above 700 is considered good.
In “The Successful First Home Buyer”, it suggests organising your debts from the highest interest rates to lowest interest rates. Basically, paying off debt is good, but it makes sense to pay off the 25% p.a. debt before you pay off, for example, your car finance on 10% p.a. If both loans were $10,000, the former would be costing you $2,500 per year; the latter is costing you $1,000 per year.
There is an exception to this rule. If you are facing an income hurdle, in other words you can’t get the mortgage you need because your income is maxed out, it may be a good strategy to pay back loans with small outstanding amounts.
So even if you have debt thanks to a ridiculously expensive impulse buy of a variegated pot plant, you now have the tools to get back on track and into a home of your own. Just make sure to put that phone away when you feel the need to click the buy now button.
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