You may have heard the term “bad debt”. But what is it? Is all debt bad? Can bad debt become good debt?
In “The Successful First Home Buyer”, I suggest 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 one exception I can think of for this rule. If you are facing an income hurdle, in other words you can’t get any more mortgage because your income is maxed out, it may be a good strategy to pay back your Student Loan.
Let’s say you had $2,000 left on your Student Loan and your income was stopping you from borrowing any more to purchase your first home. Paying this loan off would increase your available income by 12% giving you a large boost in what you might be able to afford.
The definition of good debt is one that will generate long-term income or grow in value. So a Credit Card taken out to purchase $500 shoes would probably be viewed as bad debt. There is no long-term income or increase in value generated from the purchase (no, nice shoes for a job interview don’t count!).
Alternatively, property will most likely grow in value over the long term. It also has the potential to generate income. So at face value, mortgages don’t appear to be bad debt.
Over the long term, property tends to go up in value which makes a mortgage a good debt. But what about as a short term debt?
There are no guarantees that the property market is going to increase in the next 3-5 years. It’s therefore possible that you may not be better off by taking out a mortgage. Is there an easy way to calculate if you’d be better off? Here’s one idea.
Let’s say you are looking to buy a house for $650,000 and you’re going to borrow $500,000. The mortgage payments for this would $584 per week. $432 per week would be to the bank (interest payment) and $152 per week would be towards the mortgage (principal payment). In other words, $432 per week is being thrown away each week on interest.
But if you didn’t purchase a house, you were always going to pay rent somewhere, which is money that is thrown away too. Would that same house have cost you more or less than $432 per week? If the same house would cost you $600 per week to rent, then an interest payment of $432 is a better situation for you (even if you expect no growth in the value of the property).
However, if you could rent that property for $350 per week and you’re only going to hold the property for a short time in a flat market, it’s possible to view the mortgage as a bad debt.
We've all seen the billboards advertising loans at 8% per week. They are generally predatory and terrible for all involved. But, believe it or not, they weren't originally.
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. 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.
Microfinance (the service of very small loans to produce income) has a function in the world. Let me clear, 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.
Good or bad debt? It comes down to what you're borrowing the money for. Will the new debt make your situation better or worse? Is it going to stretch you beyond what you can handle or is it going to save you money?
Some activities you can do now to improve your debt:
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