The concept of good debt verses bad debt has come up a lot lately. Most people seem confused by the idea. 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.
You can usually claim a tax deduction on any debt you’ve acquired for the purpose of making money. 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. So, if you have an investment property, you are able to claim a tax deduction on the interest portion of the repayments only.
You can usually claim a tax deduction on any debt you’ve acquired for the purpose of making money
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 at 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.
The right strategy for you will depend on your personal financial situation, but knowing the distinction between the two is a good place to start.
Featured image via Pixabay under Creative Commons CC0
Cara Brett is the Director and Senior Financial Adviser at Bounce Financial. Having worked in the financial services industry since 2003, she saw an opportunity to work with the young professionals and the movers and shakers in Brisbane, and so Bounce was born.