Good debt and bad debt, how to consolidate and save

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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Learn more about home loans

What is an interest-only loan? How do I work out interest-only loan repayments?

An ‘interest-only’ loan is a loan where the borrower is only required to pay back the interest on the loan. Typically, banks will only let lenders do this for a fixed period of time – often five years – however some lenders will be happy to extend this.

Interest-only loans are popular with investors who aren’t keen on putting a lot of capital into their investment property. It is also a handy feature for people who need to reduce their mortgage repayments for a short period of time while they are travelling overseas, or taking time off to look after a new family member, for example.

While moving on to interest-only will make your monthly repayments cheaper, ultimately, you will end up paying your bank thousands of dollars extra in interest to make up for the time where you weren’t paying off the principal.

What is a bad credit home loan?

A bad credit home loan is a mortgage for people with a low credit score. Lenders regard bad credit borrowers as riskier than ‘vanilla’ borrowers, so they tend to charge higher interest rates for bad credit home loans.

If you want a bad credit home loan, you’re more likely to get approved by a small non-bank lender than by a big four bank or another mainstream lender.

What is a debt service ratio?

A method of gauging a borrower’s home loan serviceability (ability to afford home loan repayments), the debt service ratio (DSR) is the fraction of an applicant’s income that will need to go towards paying back a loan. The DSR is typically expressed as a percentage, and lenders may decline loans to borrowers with too high a DSR (often over 30 per cent).

How do I refinance my home loan?

Refinancing your home loan can involve a bit of paperwork but if you are moving on to a lower rate, it can save you thousands of dollars in the long-run. The first step is finding another loan on the market that you think will save you money over time or offer features that your current loan does not have. Once you have selected a couple of loans you are interested in, compare them with your current loan to see if you will save money in the long term on interest rates and fees. Remember to factor in any break fees and set up fees when assessing the cost of switching.

Once you have decided on a new loan it is simply a matter of contacting your existing and future lender to get the new loan set up. Beware that some lenders will revert your loan back to a 25 or 30 year term when you refinance which may mean initial lower repayments but may cost you more in the long run.

How can I pay off my home loan faster?

The quickest way to pay off your home loan is to make regular extra contributions in addition to your monthly repayments to pay down the principal as fast as possible. This in turn reduces the amount of interest paid overall and shortens the length of the loan.

Another option may be to increase the frequency of your payments to fortnightly or weekly, rather than monthly, which may then reduce the amount of interest you are charged, depending on how your lender calculates repayments.

Who has the best home loan?

Determining who has the ‘best’ home loan really does depend on your own personal circumstances and requirements. It may be tempting to judge a loan merely on the interest rate but there can be added value in the extras on offer, such as offset and redraw facilities, that aren’t available with all low rate loans.

To determine which loan is the best for you, think about whether you would prefer the consistency of a fixed loan or the flexibility and potential benefits of a variable loan. Then determine which features will be necessary throughout the life of your loan. Thirdly, consider how much you are willing to pay in fees for the loan you want. Once you find the perfect combination of these three elements you are on your way to determining the best loan for you. 

How do I know if I have to pay LMI?

Each lender has its own policies, but as a general rule you will have to pay lender’s mortgage insurance (LMI) if your loan-to-value ratio (LVR) exceeds 80 per cent. This applies whether you’re taking out a new home loan or you’re refinancing.

If you’re looking to buy a property, you can use this LMI calculator to work out how much you’re likely to be charged in LMI.

What happens to my home loan when interest rates rise?

If you are on a variable rate home loan, every so often your rate will be subject to increases and decreases. Rate changes are determined by your lender, not the Reserve Bank of Australia, however often when the RBA changes the cash rate, a number of banks will follow suit, at least to some extent. You can use RateCity cash rate to check how the latest interest rate change affected your mortgage interest rate.

When your rate rises, you will be required to pay your bank more each month in mortgage repayments. Similarly, if your interest rate is cut, then your monthly repayments will decrease. Your lender will notify you of what your new repayments will be, although you can do the calculations yourself, and compare other home loan rates using our mortgage calculator.

There is no way of conclusively predicting when interest rates will go up or down on home loans so if you prefer a more stable approach consider opting for a fixed rate loan.

What happens when you default on your mortgage?

A mortgage default occurs when you are 90 days or more behind on your mortgage repayments. Late repayments will often incur a late fee on top of the amount owed which will continue to gather interest along with the remaining principal amount.

If you do default on a mortgage repayment you should try and catch up in next month’s payment. If this isn’t possible, and missing payments is going to become a regular issue, you need to contact your lender as soon as possible to organise an alternative payment schedule and discuss further options.

You may also want to talk to a financial counsellor. 

How personalised is my rating?

Real Time Ratings produces instant scores for loan products and updates them based what you tell us about what you’re looking for in a loan. In that sense, we believe the ratings are as close as you get to personalised; the more you tell us, the more we customise to ratings to your needs. Some borrowers value flexibility, while others want the lowest cost loan. Your preferences will be reflected in the rating. 

We also take a shorter term, more realistic view of how long borrowers hold onto their loan, which gives you a better idea about the true borrowing costs. We take your loan details and calculate how much each of the relevent loans would cost you on average each month over the next five years. We assess the overall flexibility of each loan and give you an easy indication of which ones are likely to adjust to your needs over time. 

How often is your data updated?

We work closely with lenders to get updates as quick as possible, with updates made the same day wherever possible.

How can I get a home loan with no deposit?

Following the Global Financial Crisis, no-deposit loans, as they once used to be known, have largely been removed from the market. Now, if you wish to enter the market with no deposit, you will require a property of your own to secure a loan against or the assistance of a guarantor.

How much of the RBA rate cut do lenders pass on to borrowers?

When the Reserve Bank of Australia cuts its official cash rate, there is no guarantee lenders will then pass that cut on to lenders by way of lower interest rates. 

Sometimes lenders pass on the cut in full, sometimes they partially pass on the cut, sometimes they don’t at all. When they don’t, they often defend the decision by saying they need to balance the needs of their shareholders with the needs of their borrowers. 

As the attached graph shows, more recent cuts have seen less lenders passing on the full RBA interest rate cut; the average lender was more likely to pass on about two-thirds of the 25 basis points cut to its borrowers.  image002

What is 'principal and interest'?

‘Principal and interest’ loans are the most common type of home loans on the market. The principal part of the loan is the initial sum lent to the customer and the interest is the money paid on top of this, at the agreed interest rate, until the end of the loan.

By reducing the principal amount, the total of interest charged will also become smaller until eventually the debt is paid off in full.