Good vs bad debt

Plus, why having a tailored debt reduction plan matters.

If you're like most people trying to get ahead, you have probably heard of the terms 'good debt' and 'bad debt'.

So, what do they each mean? And, can any sort of debt REALLY be a good thing?

Put simply, while there are many definitions of what constitutes good vs bad debt, broadly speaking here's the deal:

GOOD DEBT
Good debt is debt that's used to increase your net worth by buying assets that either increase in value, generate an income or both. Good debt can be seen as an investment with bonus' such as any interest payable on good debt can be tax deductible.

However, good debt can easily turn bad if you're: paying a higher interest rate on your mortgage than otherwise available, carrying too much debt into retirement, or your monthly debt payment (including your mortgage and credit cards) is more than approximately 35 per cent of your gross monthly income.

In these circumstances, it could be time to reassess your personal finances to make sure your debt stays, well, good!

BAD DEBT
Bad debt is money borrowed for things that don't increase in value or worse continue to depreciate such as a car. Bad debt is generally a result of lifestyle acquisitions, that means everything from dining out, to going to the football on the weekend, to taking a family holiday costs money. What's more, bad debt does not generate an income steam and any interest cannot be claimed as a tax deduction.

Ultimately, at FinancePath, we believe there's one important question to ask yourself when preparing to take on debt of any type:

Do I have a clear plan to pay off (or at least manage) my debt?

Because, regardless of whether debt is used to purchase an appreciating or depreciating asset, debt is bad without a clear plan to pay it off. Smart money management is about making sure you not only improve your financial position over time, but avoid financial stress along the way.
For example, even if your property is going up in value and is therefore good debt by definition it can turn sour if you're struggling under the pressure of a mortgage.

So, how do you reduce debt?
A smart financial strategy should be tailored to suit your personal circumstances and money needs. After all, everyone's finance path is different. However, there are a few obvious places to start when it comes to paying off debt:

1. Find out if you're receiving the most competitive interest rate available on your mortgage.

2. If you have several sources of debt, investigate refinancing to consolidate debt into your mortgage so that you can make regular repayments to one place.

3. Work out if you have the right type of insurance this can be a forgotten area where you can save money.

4. Compartmentalise your income and expenses to ensure greater accountability over your spending. Understanding what and where you are spending your money is the first step in a sound financial plan.

At FinancePath we've helped customers pay off more than $40 million in debt, find out how at our online resource centre for Reducing Debt or call now for a free 10-minute money consultation, 1300 780 440.