If a debt is not used to invest and generate an income, it carries no tax benefit and is therefore non-deductible. It is commonly referred to as a ‘BAD debt’. A debt that is drawn to invest (into say an investment property where there is an income derived being the rent), carries tax deductions, and can be called a ‘GOOD’ debt.
Using the example of a fictitious couple, Bob and Belinda who invest in direct property (outside of super), we illustrate how you can use good debt to pay off your bad debt sooner.
Bob and Belinda are 45, and they wish to purchase an investment property. They have a home they live in worth $500,000 with a debt of $250,000. Bob makes $110,000pa and Belinda makes $40,000pa.
Because their home mortgage debt is low, they have equity available to invest. They could draw up to 80% of the value of their home ($150,000, which would bring them to $400,000 in total debt) without being penalised with Lenders Mortgage Insurance (LMI).
Using equity to invest into another property can help pay down existing non-deductible debt, commonly referred to as ‘BAD’ debt.
If Bob and Belinda were to draw a second loan of $100,000 from their home, this could be used to cover a 20% deposit and costs (stamp duty, legals etc.) to buy a $400,000 investment property. The loan on the investment property would be a ‘GOOD’ debt.
Strategies to pay down bad debt
There are a number of ways that are available to pay down their BAD debt.
One of the simplest is to use tax deductions from a larger tax return, which can be put towards their debt. The interest from the debt, and any other costs (like rates, body corporate and insurance etc) are tax deductible. Depreciation can also be claimed on the property as a tax deduction, and can mean a huge increase in Bob and Belinda’s tax return.
We could also set their home mortgage up with an offset account. This provides a way for both their incomes and rent to pay down the debt. As interest on the debt is calculated daily, we want to have as much money in the offset account as we can, for as long as we can. This simple step can reduce the term of a mortgage considerably!
If they feel comfortable using a credit card, we could set them up with a card that has a small limit equal to their monthly expenses with a small buffer. Bob and Belinda could use the credit card for all their day-to-day expenses, leaving their pay in the offset account. When the interest-free period on their credit card approaches, they draw funds out of their offset account and pay off their credit card in its entirety. Most credit cards have between 30-50 days interest free. This is one and a half months where money can sit in the offset account, reducing the interest on their BAD debt.
The above strategies are a way of introducing extra incomes to help pay down their BAD debt. By having all their incomes and the rent paid into their offset, and only drawing it back out at the last minute when credit cards or loan payments are due, and by having a larger tax return at the end of the year, Bob and Belinda should be able to pay down their BAD debt in a fraction of the time, and hopefully see some capital gain on their investment property too!
When the BAD debt is paid off, they are able to start attacking the GOOD debt on the investment property, or further expand their portfolio by purchasing another investment.
If you’d like to learn more about the financial strategies available to you to build your wealth for retirement, contact us today for a free consultation.