Good debt and bad debt, how to consolidate and save

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

Can I get a home loan if I owe taxes?

Owing money to the Australian Tax Office is not an ideal situation, but it doesn’t mean you cannot qualify for a home loan. Lenders will take into account your tax debt, your history of repaying the debt and your other financial circumstances, while reviewing your home loan application. 

While some banks may not look favourably upon your debt to the ATO, some non-bank lenders may be willing to help. They will look into the reasons for your tax debt and also take into account the steps you have taken to repay it before deciding whether to offer you the loan or not. Having said that, there are no guarantees - it depends on your whole financial picture.

Here are a few steps that you can take to improve your chances of getting approved for a home loan.

  • Demonstrate evidence of income.
  • Manage your debt by paying it off in installments.
  • Offer an explanation for your tax debt and a plan to pay it off.
  • Do what you can to stay out of court or attract debt collection agencies.

 

What do people do with a Macquarie Bank reverse?

There are a number of ways people use a Macquarie Bank reverse mortgage. Below are some reasons borrowers tend to release their home’s equity via a reverse mortgage:

  • To top up superannuation or pension income to pay for monthly bills;
  • To consolidate and repay high-interest debt like credit cards or personal loans;
  • To fund renovations, repairs or upgrades to their home
  • To help your children or grandkids through financial difficulties. 

While there are no limitations on how you can use a Macquarie reverse mortgage loan, a reverse mortgage is not right for all borrowers. Reverse mortgages compound the interest, which means you end up paying interest on your interest. They can also affect your entitlement to things like the pension It’s important to think carefully, read up and speak with your family before you apply for a reverse mortgage.

What are the features of home loans for expats from Westpac?

If you’re an Australian citizen living and working abroad, you can borrow to buy a property in Australia. With a Westpac non-resident home loan, you can borrow up to 80 per cent of the property value to purchase a property whilst living overseas. The minimum loan amount for these loans is $25,000, with a maximum loan term of 30 years.

The interest rates and other fees for Westpac non-resident home loans are the same as regular home loans offered to borrowers living in Australia. You’ll have to submit proof of income, six-month bank statements, an employment letter, and your last two payslips. You may also be required to submit a copy of your passport and visa that shows you’re allowed to live and work abroad.

Why does Westpac charge an early termination fee for home loans?

The Westpac home loan early termination fee or break cost is applicable if you have a fixed rate home loan and repay part of or the whole outstanding amount before the fixed period ends. If you’re switching between products before the fixed period ends, you’ll pay a switching break cost and an administrative fee. 

The Westpac home loan early termination fee may not apply if you repay an amount below the prepayment threshold. The prepayment threshold is the amount Westpac allows you to repay during the fixed period outside your regular repayments.

Westpac charges this fee because when you take out a home loan, the bank borrows the funds with wholesale rates available to banks and lenders. Westpac will then work out your interest rate based on you making regular repayments for a fixed period. If you repay before this period ends, the lender may incur a loss if there is any change in the wholesale rate of interest.

Can I take a personal loan after a home loan?

Are you struggling to pay the deposit for your dream home? A personal loan can help you pay the deposit. The question that may arise in your mind is can I take a home loan after a personal loan, or can you take a personal loan at the same time as a home loan, as it is. The answer is that, yes, provided you can meet the general eligibility criteria for both a personal loan and a home loan, your application should be approved. Those eligibility criteria may include:

  • Higher-income to show repayment capability for both the loans
  • Clear credit history with no delays in bill payments or defaults on debts
  • Zero or minimal current outstanding debt
  • Some amount of savings
  • Proven rent history will be positively perceived by the lenders

A personal loan after or during a home loan may impact serviceability, however, as the numbers can seriously add up. Every loan you avail of increases your monthly installments and the amount you use to repay the personal loan will be considered to lower the money available for the repayment of your home loan.

As to whether you can get a personal loan after your home loan, the answer is a very likely "yes", though it does come with a caveat: as long as you can show sufficient income to repay both the loans on time, you should be able to get that personal loan approved. A personal loan can also help to improve your credit score showing financial discipline and responsibility, which may benefit you with more favorable terms for your home loan.

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 are the different types of home loan interest rates?

A home loan interest rate is used to calculate how much you’ll pay the lender, usually annually, above the amount you borrow. It’s what the lenders charge you for them lending you money and will impact the total amount you’ll pay over the life of your home loan. 

Having understood what are home loan rates in general, here are the two types you usually have with a home loan:

Fixed rates

These interest rates remain constant for a specific period and are a good option if you’re a first-time buyer or if you’re looking for a fixed monthly repayment. One possible downside of a fixed rate is that it may be higher than a variable rate. Also, you don’t benefit from any lowering of interest rates in the market. On the flip side, if rates go up, your rate won’t change, possibly saving you money.

Variable rates

With variable interest rates, the lender can change them at any time. This change can be based on economic conditions or other reasons. Changes in interest rates could be beneficial if your monthly repayment decreases but can be a problem if it increases. Variable interest rates offer several other benefits often not available with fixed rate home loans like redraw and offset facilities and free extra repayments. 

Can I get a home renovation loan with bad credit?

If you're looking for funds to pay for repairs or renovations to your home, but you have a low credit score, you need to carefully consider your options. If you already have a mortgage, a good starting point is to check whether you can redraw money from that. You could also consider applying for a new home loan. 

Before taking out a new loan, it’s good to note that lenders are likely to charge higher interest rates on home repair loans for bad credit customers. Alternatively, they may be willing to lend you a smaller amount than a standard loan. You may also face some challenges with getting your home renovation loan application approved. If you do run into trouble, you can speak to your lender and ask whether they would be willing to approve your application if you have a guarantor or co-signer. You should also explain the reasons behind your bad credit rating and the steps that you’re taking to improve it. 

Consulting a financial advisor or mortgage broker can help you understand your options and make the right choice.

What is the average length of a home loan?

Most Aussie lenders offer home loans with a 30-year term, meaning that you should pay back the full loan amount and the interest you owe on the amount in 30 years. 

However, home loans can also have a shorter or longer term. They may be as low as ten years or up to 45 years, depending on the product and lender. 

It’s worth remembering that a longer loan term usually means you’ll end up paying a lot more interest in total, but your scheduled repayments may be more manageable. In contrast, you could opt for a shorter loan term if you are comfortable making large repayments in exchange for paying less interest over the term of the loan.

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).

When do mortgage payments start after settlement?

Generally speaking, your first mortgage payment falls due one month after the settlement date. However, this may vary based on your mortgage terms. You can check the exact date by contacting your lender.

Usually your settlement agent will meet the seller’s representatives to exchange documents at an agreed place and time. The balance purchase price is paid to the seller. The lender will register a mortgage against your title and give you the funds to purchase the new home.

Once the settlement process is complete, the lender allows you to draw down the loan. The loan amount is debited from your loan account. As soon as the settlement paperwork is sorted, you can collect the keys to your new home and work your way through the moving-in checklist.

When does Commonwealth Bank charge an early exit fee?

When you take out a fixed interest home loan with the Commonwealth Bank, you’re able to lock the interest for a particular period. If the rates change during this period, your repayments remain unchanged. If you break the loan during the fixed interest period, you’ll have to pay the Commonwealth Bank home loan early exit fee and an administrative fee.

The Early Repayment Adjustment (ERA) and Administrative fees are applicable in the following instances:

  • If you switch your loan from fixed interest to variable rate
  • When you apply for a top-up home loan
  • If you repay over and above the annual threshold limit, which is $10,000 per year during the fixed interest period
  • When you prepay the entire outstanding loan balance before the end of the fixed interest duration.

The fee calculation depends on the interest rates, the amount you’ve repaid and the loan size. You can contact the lender to understand more about what you may have to pay. 

Cash or mortgage – which is more suitable to buy an investment property?

Deciding whether to buy an investment property with cash or a mortgage is a matter or personal choice and will often depend on your financial situation. Using cash may seem logical if you have the money in reserve and it can allow you to later use the equity in your home. However, there may be other factors to think about, such as whether there are other debts to pay down and whether it will tie up all of your spare cash. Again, it’s a personal choice and may be worth seeking personal advice.

A mortgage is a popular option for people who don’t have enough cash in the bank to pay for an investment property. Sometimes when you take out a mortgage you can offset your loan interest against the rental income you may earn. The rental income can also help to pay down the loan.