Owe, the pain of dirty debt most foul- 28th December 2002
James Dunn - The Australian
There's nothing wrong with getting yourself into debt. What's important is whether it's clean or dirty, as James Dunn reports
THERE's no question Australians are comfortable with debt. Trouble is, we haven't been too smart about the type of debt we use. In 1990, Australian household debt stood at $150 billion. It's now $590 billion -- in what's recognised as one of the biggest markets in the world for home loans and credit cards.
The good news is we're becoming more debt savvy, and are making greater use of a range of financial strategies that can turn debt into wealth.
Andrew Lawless, technical services manager at funds management and insurance group MLC, says consumers are more atuned to the distinction between efficient and inefficient debt.
Unfortunately, he says, many Australians are more familiar with the latter.
``Inefficient debt is where you borrow to buy goods, services and assets that don't generate income for you, are known to depreciate in value, or have no value once they're used,'' he says. Because there's no tax deduction on the interest cost, you have to rely on your own resources to service the debt.
Efficient debt involves buying assets that generate assessable income, and have the potential to increase in value.
``You can use the income generated by the asset to help repay the loan,'' Lawless says. ``And you get a tax deduction on the interest cost of the loan.
``Not only is this kind of debt easier to service, it can also accelerate the creation of wealth.''
Peter Thornhill, principal of educator motivatedmoney.com, calls it clean and dirty debt.
``Clean debt is taken on for the purpose of investment to create wealth, and gives rise to a tax deduction,'' he says. ``Dirty debt is simply used for consumption, and doesn't give a tax deduction.''
Lawless gives these examples of inefficient debt:
A personal loan to buy a car or holiday. Neither generates income, and the interest isn't deductible.
Not paying off a credit card loan within the interest-free period. The loan isn't deductible, and the purchases usually have little resale value.
An owner-occupier home loan. The home may increase in value, but it doesn't produce income so the cost of servicing the loan isn't deductible.
Examples of efficient debt include:
Borrowing to buy assets such as shares or property (directly or through a managed fund). The asset has the potential to rise in value, and generates income. The interest is deductible.
Borrowing to buy shares and/or invest in a managed funds. The interest is deductible because the funds go to income-producing securities. (Lawless prefers an ``internally'' geared fund that borrows to leverage its investments: the interest is deductible for the fund rather than the investor, but the investor doesn't face the possibility of a ``margin call'' (having to sell shares or fund units if the investment falls in value).
Home-equity loans, which allow you to borrow on the equity and invest where you choose. If deriving assessable income from your new investment, the interest on the loan is deductible.
Wherever possible, says Lawless, inefficient debt should be swapped for efficient debt.
A common way to do this is to consolidate inefficient debts into a loan with the lowest interest.
``If you have a home loan, and you have sufficient equity in your house, a good idea is to increase the mortgage and use the borrowed funds to pay off any debt on personal loans or credit cards,'' he says. ``You save on the interest cost, and your financial situation is simplified into one loan.''
Lawless recommends using a home loan as an emergency cash holding, via a redraw facility or a 100 per cent offset account (money held in an account that reduces, dollar for dollar, the loan principal and, therefore, the interest payable).
``This money effectively earns the rate of interest charged by your home loan, which is higher than that payable by a cash account,'' he says. ``If you maintain your previous payments, you'll further reduce the term of your loan, and save even more interest.''
When inefficient debt is under control, Lawless says, you can start to create wealth with efficient debt, such as gearing into appropriate investments.
``Borrowing increases the amount of money you have to invest and therefore boosts your potential return,'' he says. If you negatively gear (where the income from the investment is less than the interest cost), there may also be tax deductions.
But you should be comfortable with the fact that gearing can increase losses if the investment falls in value, just as it can increase gains if it rises.
Lawless says it's important to gear conservatively. Exactly what that means for you is best worked out with an investment professional.
Thornhill claims that borrowing to buy residential property is actually dirty debt.
``It's not consumption, but I would argue that it's poor-quality investment,'' he says. ``I know them's fighting words in a society that's still only comfortable with debt when it's against property, but I believe that's an illusion created by the fact that we simply got used to inflation.
``Inflation ramps up the value of our house, while also reducing the value of our mortgage. It's more correct to say that inflation pushes up the price of our house -- not its value.''
``The fact of the matter is that we don't like to trade down, so even if we `make money' on our house, if we want to sell and move to another similar house, we have to pay the same or more.''
Australia has one of the highest rates of home ownership in the world. The Australian Bureau of Statistics says 70 per cent of Australians either own their homes or are paying them off.
Thornhill says Australians' comfort with debt has sprung from this one-dimensional view of the effect of borrowing to buy property.
``I don't think debt is wise when it's undertaken to buy property. But even that isn't as bad as borrowing through a credit card to fund a lifestyle you can't afford,'' he says.
``As a mechanism for paying for goods and services, inside the interest-free period a credit card is wonderful. I'm certainly in favour of using a bank's money for free -- then you have your own funds to invest in wealth creation.''
According to the Australian Consumers Association, the number of credit cards has grown more than 25 per cent a year over the past six years.
The rise in the popularity of credit cards has eclipsed personal loans. Anyone seeking a personal loan of less than $10,000 these days is likely to be offered a credit card -- or a limit extension on an existing card.
Australia is now the sixth largest credit card market in the world. Our credit card debt is at a record $21.9 billion, with the average person owing more than $2200.
10 ways to reign in debt
Strategy & Key benefits
1-Consolidate your debts to save money
* Reduce the interest rate applying to your debts
* Pay off your inefficient debt sooner and save interest
* Simplify your personal finances
2-Use your emergency cash reserve more effectively
* Achieve a higher after-tax return on your money
* Pay off your inefficient debt sooner and save interest (while retaining full access to your money)
3-Harness your cash flow to reduce inefficient debt
* Pay off your inefficient debt sooner and save interest
* Create equity in the family home to then borrow for investment
4-Use borrowed money to build wealth
* Accelerate the creation of wealth by having more money invested
* Reduce tax on other income through negative gearing
5-Gear your investments gradually by borrowing in instalments
* Build wealth sooner in a disciplined and controlled manner
* Have the flexibility to adjust your gearing strategy if necessary
6-Transform your debt using a financial windfall
* Build wealth by converting inefficient debt into efficient debt
* Use the income and tax savings from gearing to further reduce inefficient debt
7-Build wealth via debt recycling
* Build an investment portfolio sooner by replacing inefficient debt with efficient debt on a regular basis
* Use the income and tax savings from gearing to further reduce inefficient debt and build your investment portfolio
8-Offset your investment loan to retain tax efficiency
* Save interest by making additional repayments into an investment loan offset account
* Withdraw money for any purpose without affecting the tax deductibility of the loan
9-Save tax by making the correct ownership decisions
* Boost returns by minimising the amount of tax payable over the life of a geared investment
* Achieve flexibility by using your partner's or joint assets as security for borrowing
10-Leverage your investment via an internally geared share fund
* Reduce paperwork and borrowing costs
* Allow super fund members to take advantage of gearing