Debt is the Dr Jekyll and Mr Hyde of wealth creation – it can tear apart your dreams of financial security or actually create it.
Most of us realise that credit cards or personal loans aren’t the most sensible way to pay for things, but going into debt can be the best way to build wealth. After all, a mortgage to buy your own home is a debt many people aspire to take on.
Using debt to build assets which increase in value – such as a home or share portfolio – makes sense. Borrowing to fund a new pair of shoes or pay off a huge mobile phone bill doesn’t.
Financial adviser and author Noel Whittaker says borrowing to build wealth is a sound financial strategy that most people don’t explore properly.
“If I said to you, ‘can you save $100,000 to buy some shares or a house’, you would say, ‘no, I can’t afford that’. But if I said to you, ‘could you afford a tax-deductible payment of $8000 a year to fund a share portfolio’, you might well be able to,” says the author of Controlling Credit Cards and Borrowing to Invest.
“Good debt is used to buy property and shares that increase in value over time. Bad debt is used to fund consumer things like holidays and clothes and things that decline in value.”
We all know about ballooning levels of personal debt and how scary it can be to open up a credit card statement when you’ve had a few impulse shopping moments. But when is debt truly bad?
Whittaker says anyone paying for a lifestyle costing more than they earn is at risk of being in bad debt. “You don’t have to borrow for personal, consumer things – otherwise you are on the slippery slope of spending more than you earn,” says the director of Whittaker Macnaught, a financial planning company.
That’s not to say we must live a hairshirt existence or banish all credit cards. “I use a credit card for the points and convenience but I don’t pay a cent in interest because I pay it in full before the interest-free period is up,” he says.
“Plenty of people never pay off their credit card and are happy paying interest to the banks. Personally, I’d rather use my money to build my assets.”
Whittaker says he has seen “truly desperate cases” of people with debts they cannot repay. “Most of us are not that desperate, but if you are, then see a debt counsellor who can make arrangements to stave off bankruptcy,” he says. “Most people simply need to turn over a new leaf and commit to getting rid of debt.”
Whittaker says a popular debt-reduction strategy is consolidating all debts into one loan and paying it off quickly.
“I only recommend this if people really are going to commit to changing the way they spend,” he says. “There’s no point consolidating a $5000 credit card debt if you will have another $5000 of credit card debt in four months time.”
He warns that debt consolidation can be explosive for people who don’t change their spending habits. “Consolidate your debt only if you are genuine, otherwise you are simply taking on more debt for no good reason.”
He recommends the best way to attack debt is to:
“If you do that, you will find you have more and more firepower to attack the next debt,” Whittaker says.
Whittaker says buying your own home is a sound strategy for future financial security. “Most people need to borrow to build their asset base,” he says. “If you know that Aunty Bessie is going to die soon and leave you $2 million, then perhaps you don’t – but most people need to.”
He says the optimum time to pay off a home loan is over 10 years – that way, the homebuyer pays the least amount of interest for the greatest possible gain.
“People should pay at least $8 per thousand dollars borrowed each month to cover interest and capital repayments,” he says. That means on a $200,000 loan, Whittaker suggests minimum monthly payments of $1600.
“The ideal is to pay $12 a month per thousand dollars borrowed, and that will knock the loan off in 10 years.” That would take repayments on a $200,000 loan up to $2400 a month – but after 10 years, there would be no more mortgage payments and that $2400 a month could be used to buy shares.
Borrowing to buy shares can be complex, but the interest costs are usually tax deductible against the income generated by the shares. “It’s not as hard as people think,” he says. “With the booming sharemarket and franking credits on the shares, it’s almost impossible to be able to negatively gear shares at the moment.”
And there lies the risk. “With property and shares booming, there is a risk of a market fall,” he says. “Borrowing always entails a risk – you could lose your job, the market could crash or things can go wrong. Most people are predicting there will be a negative year at some time, but who knows when?”
Over a decade or more, housing and shares have proved to grow in value. “Even in the 1987 stockmarket crash when the market fell by 60 per cent, the people that owned shares at the beginning of the year still had 10 per cent gains.”
SAVE AND PLAN YOUR SPENDING: Using lay-by and interest-free periods can be a better way to pay for large purchases than simply whipping out the credit card.
ARRANGE YOUR DEBT EFFICIENTLY: Always have a gameplan and don’t have a punter’s mentality. Whittaker recommends lining up your debts from smallest to largest and using all your firepower to pay off the smallest debt first.
PAY THE RIGHT DEBT FIRST: Debts should be paid off and prioritised according to the highest interest rate. The higher the charges, the quicker you want the balance down.
MATCH YOUR CREDIT CARD TO SPENDING STYLE: If you are a mad shopper who constantly carries credit card debt, ensure you have a card with the lowest rate of interest possible. If you can be a disciplined credit card user, aim for a card with a long interest-free period before you are hit with any charges.
DON’T CONSOLIDATE INTO A HOME LOAN WITHOUT CHANGING YOUR SPENDING: Rolling debt into a home loan or consolidation loan can be a great way to pay everything off at a lower interest rate – but make sure you increase your monthly or fortnightly repayments rather than drag out a $1000 credit card debt over another 25 years.
BORROW TO BUILD ASSETS: Borrowing to buy your own home and shares makes sense. But there is always a risk with borrowing – the market could crash, people lose jobs and things go wrong. Think about the risks versus the rewards before embarking on the journey.