In many cases, some debt can actually be an important part of the wealth creation process.
There are different kinds of debt: good debt and bad debt. The main difference between good debt and bad debt is how much income it is capable of generating.
For example, a credit card debt will almost always be bad because it will not generate any income (unless you have made a particularlyclever purchase). A mortgage for an investment property, on the other hand, may be a good debt because it can eventually pay for itself and then continue to generate additional income.
Generally speaking, most people will accrue bad debts in times of financial hardship. Credit cards and personal loans are the most common and problematic forms of bad debt.
In many cases, bad debts such as these can continue to chase you for some time, even if your financial situation improves significantly.
Usually, as people’s financial situation starts to improve, they begin investigating the possibility of taking on debt to use as leverage to secure wealth accumulating assets.
Unfortunately, if you have any remaining bad debts it may impact your borrowing capacity, and drawn out repayment periods can see your household cashflow being wasted on unnecessary interest payments.
You should also be careful about how much debt you are taking on, even if it is good debt. A slight rise in interest rates can push your repayments up significantly, and if you can’t service a debt it might land you in a world of financial trouble.
There are two steps that you can take to try to make sure that your debts are good debts that are working towards wealth creation.
First, you should aim to reduce your existingbad debts. If it is possible, you should avoid accumulating any additional credit card or personal loan charges. If you struggle to control your credit card spending, you may consider replacing it with a debit card. Working out a detailed household budget each week will make it easier for you to see where your money may be slipping away.
Second, you should start looking into what kind of good debt might be beneficial for you. When you are considering taking on debt for the purposes of long term wealth creation there are three things you should look at:
- The potential that the debt and associated asset will have to generate income, both currently and in the medium-to-long term future. You should ascertain if this is sufficient to justify the interest payments that you will need to make.
- Whether or not the asset you are purchasing with the borrowed funds is likely to appreciate or depreciate in value. For example, borrowing to buy a new car would rarely qualify as a good debt because cars almost always depreciate in value.
- What the tax arrangements surrounding the debt will be. In the case of investment properties, negative gearing can reduce your tax bill significantly. This may make the debt even more beneficial in the long term than it would have otherwise been.