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Good debt and bad debt – how to consolidate and save


Mark Bristow

Mark Bristow


Even if you didn’t pay much attention to the 2017 federal budget, you may remember how it was presented a little differently. Rather than focusing solely on surpluses versus deficits, the federal government sorted its borrowing into “good debt” and “bad debt”.

As Federal Treasurer Scott Morrison explained to a sceptical audience in the lead-up to the 2017 budget, good debt involves borrowing money to pay for an asset that’s going to add value or provide future benefits, whereas bad debt involves borrowing money to cover the cost of something that won’t provide the same kind of long-term value.

These principles not only apply to federal budgets, but to everyday household budgets as well. Here’s how to determine what good and bad debts you owe, and how you can use your good debts to help you manage any bad debts:

Good household debt

It’s true (from a certain point of view) that debt isn’t automatically a bad thing. A reasonable level of well-managed debt can allow Australians to enjoy lifestyle benefits and luxuries, or make progress towards goals that they’d never otherwise be able to achieve.

Generally, any debt that helps you to build more wealth in the long term, or otherwise puts you in a better lifestyle position, can be counted as a good debt under the right circumstances.

Home loans are often considered to be good debts. Yes, buying property involves borrowing a sometimes staggering amount of money, and can make a major impact on any household budget. But a home loan also makes the borrower the owner of a property that can serve as a roof over their head and/or an asset that can provide financial returns and potentially increase in value over time.

Other examples of good debt can include (under the right circumstances):

  • loans to finance investment in shares that can increase in value
  • loans to pay for education that can help you get a better (and/or higher-paying) job
  • loans to start a business whose revenue may one day pay for itself

Bad household debt

Bad debt is borrowed money that doesn’t provide additional financial benefits over time. At best, bad debts take a long time to pay off, and cost you more than the value of any benefits they once provided. At worst, they’re debts where interest, fees and other charges keep growing faster than you can pay them off, turning your otherwise innocuous loan into an inescapable spiral of increasing debt.

The go-to example of bad debt – as used by the Federal Treasurer – is a credit card. While credit cards play an important role in helping Australians to manage their everyday expenses, if used irresponsibly or mismanaged, they can quickly get out of control. Most credit cards require very low minimum repayments, so it can be very tempting to run up big spending debts and put off paying them back until later. Because the interest rates on credit cards tend to be on the higher side, these debts can quickly grow to be much higher than you can realistically afford to repay.

Of course, credit cards aren’t the only source of bad debt. Just about any loan can turn into a bad debt if it’s left unpaid, as the interest, fees and charges can lead to it growing to the point where you just can’t afford to keep up with your repayments.

Car loans are sometimes treated as bad debts, as unlike properties, vehicles generally depreciate in value over time, meaning you’ll more than likely end up paying much more towards a car loan than your car is ultimately worth. On the other hand, owning a car can provide significant lifestyle benefits, and if you use your car for work, it can help contribute to your overall financial well-being. Remember to carefully consider your financial situation before applying for a car loan.

How to consolidate your bad debt with your good debt and save

The simplest way to get rid of bad debt is to just pay it back, though this is rarely as easy as it sounds. If paying your debt back isn’t realistic or affordable, then another option that may be worth considering is consolidating your debts. It’s possible to do this by taking out a specialised personal loan, but another reasonable option is to refinance your existing home loan.

Refinancing a home loan is often undertaken to take advantage of a cheaper interest rate.  This reduces the loan’s minimum repayments, so borrowers can enjoy greater affordability from month to month, or pay the loan back faster and save on interest in the long term.

An alternative option when refinancing a home loan is to borrow some more money, and use it to pay off other outstanding bad debts, such as maxed out credit cards or overdue car loans. This may sound at first sound like simply swapping one type of debt out for another, but there are a few benefits to consolidating your debts, including:

  • Simpler budgeting – Rather than juggling multiple repayments for the home loan, the car loan, and each of the credit cards, you can just make the one repayment each month.
  • One interest charge – When you’re paying off multiple debts to multiple lenders each month, you’re also paying multiple interest charges. By consolidating your debts into one loan, you’ll only need to make one interest payment each month, no matter how many old debts you’ve rolled into the loan.
  • More affordable repayments – Home loan interest rates are generally lower than credit card or personal loan interest rates. When you’re only being charged interest the once at this lower rate, your monthly repayment will likely be lower than the previous combined cost of covering your various other bad debts.

What to watch out for when consolidating bad debt

One of the most important things to remember when thinking about consolidating debt is that once you’ve paid off your bad debts, don’t let them come back! If your credit card was causing you financial problems, once you’ve consolidated its debts it’s worth thinking seriously about cancelling the card rather than risking building up an all-new debt that could run out of control all over again.

Another important consideration when consolidating debt is that you likely won’t end up saving money in the long term. While your monthly repayments will likely be more affordable than paying off your bad debts separately, when you consider the longer terms of most home loans, you’ll likely be making a greater number of payments on your debt, and thus pay a higher amount of total interest, even at the lower rate, than you likely would if you pay off your smaller bad debts separately.

Consider this example (totals and interest rates are examples only and not indicative of current market rates):

BEFORE DEBT CONSOLIDATION:

Type of loan Loan amount Interest rate Loan period Monthly repayments Total interest Total cost of loan
Home loan $600,000 5% 30 years $3221 $559,535 $1,159,535
Personal loan $10,000 9% 3 years $318 $1448 $11,448
Car loan $30,000 9% 5 years $623 $7,365 $37,365
TOTALS $640,000 $4162 $568,348 $1,208,348

AFTER DEBT CONSOLIDATION

Type of loan Loan amount Interest rate Loan period Monthly repayments Total interest Total cost of loan
Home loan (refinanced with debt consolidation) $640,000 5% 30 years $3436 $596,836 $1,236,836
TOTAL SAVINGS $726 -$28,488 -$28,488

Remember: if you’re in financial hardship and struggling with bad debt, you should always carefully consider your available options and do your calculations so you can be confident that you’re making an appropriate financial decision. If you’re uncertain, seek independent financial advice, or contact the ASIC debt helpline.

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