Five important factors to consider when it comes to debt.
1. Yin and Yang
Debt can be key to building wealth, it can also be the surest way to financial disaster. Whether it’s good or bad basically depends on two things – what you’re buying with the money you borrow and how much interest you’re paying.
Debt is your friend when it’s used to buy an appreciating asset. The most obvious appreciating asset is a house. Over time, a house today will always be cheaper than one tomorrow. It’s not that housing values don’t fall sometimes, but over the past 10 years average housing prices in Australia have risen by more than 70 per cent. To boil that down further – a house that’s worth $850,000 today, cost just $500,000 a decade ago. If you had borrowed $450,000 to buy it and only paid the interest, you would have $400,000 in your pocket if you sold it.
Debt is your enemy when it’s used to buy a depreciating asset. The classic example is a car. Depreciation is the biggest single cost of car ownership. Even cars that are well maintained fall in value. Like houses, the rate of decline varies for make and model but on average, a car bought for $30,000 five years ago would be worth $11,000 today. So – if you borrowed $25,000 for a car and only paid interest you would be left with a debt of $14,000 and no car.
The rate of interest on debt directly relates to what is being bought. The more likely a debt is to be repaid in full, the lower the interest rate will be. A house appreciates, so the bank has a good chance of getting its money back. The reverse applies for a car, clothes etc. If you have a housing loan, you can use this to get a lower effective interest rate by “borrowing” from your home loan for unexpected purchases.
5. It’s Ultimately About You
Just as houses and cars have different rules, so do different people. Higher risk customers have to pay higher interest because there’s less chance that they will pay back a debt in full. That means having a stable job and a good credit rating by paying your bills on time will mean you should get a lower interest rate on money than someone who doesn’t.