We all borrow money to buy things when we don’t have the money to pay the full purchase price. Most people borrow to buy personal assets like a home but you can also borrow to access investment opportunities to help grow your wealth.
Not all debt is the same and it is important to understand how it works and consider the implications of particular strategies. While it can be a great tool to grow your wealth, if it is not carefully managed it can have the opposite effect.
WHICH LOANS SHOULD YOU REPAY FIRST?
The interest on loans to buy personal assets such as your home, car, lifestyle purchases or living expenses cannot be claimed as a tax deduction, so it makes sense to repay these debts as a priority.
Your credit card usually charges the highest rate of interest so you should aim to pay this debt off as quickly as possible while continuing to make the required repayments on your other loans.
If you currently make monthly repayments, one simple trick is to halve these amounts and pay them fortnightly instead. There are 26 fortnights in a year compared to 12 months so you will make additional repayments across the year and reduce your total interest cost and the loan term.
The fees to establish loans may depend on the type of loan. It is important to understand all the costs charged by the lender or government. This includes the cost of making extra or increased repayments and the cost of any restructuring.
If you have a Higher Education loan (HECS-HELP), this is at relatively low interest rates, so it can make sense to repay the minimum amounts on this while concentrating on repaying other loans.
BORROWING TO INVEST
If you borrow to buy an investment the interest cost and other expenses may be tax deductible. This applies to loans used to buy a rental property, shares or managed funds.
If the returns are lower than the overall costs of the investment then you are able to claim this as a tax deduction against your other income at your marginal income tax rate. This is widely known as negative gearing.
This makes sense if, over time, the capital gain from the investment exceeds your after-tax losses. But you need to be very careful with this strategy, because if the value of the investment falls you will amplify your capital losses while also losing money on your after-tax cash flow.
You should never borrow to invest just for the sake of the tax deduction, or in the hope that markets always rise. You also need to be confident that you can ride out periods when the returns are lower, such as when you have no tenants in a rental property.
Debt consolidation involves combining several loans into one loan account. For example, you may increase your home loan to repay your car loan and credit card debt.
You need to be disciplined when consolidating your debt to ensure you do not simply increase your overall debt from other sources.
Credit cards can be wonderfully convenient, but they can also be a real trap for some. If you seem to have ongoing credit card debt that you never seem to pay off fully then this will end up costing you a lot of money. In addition, it may prevent you obtaining or paying off other important loans, such as your home or investment loans.
All lending requires discipline to ensure that you do not over-commit yourself and are able to make repayments, and preferably pay them sooner than required.
You should ensure that you have adequate life insurance (e.g. life, total and permanent disability and income protection) so that you can continue to meet your loan repayments or repay the debt if your income stops or reduces due to death or illness.
Sensible use of debt should be considered as part of your overall financial plan and you should seek professional advice before using debt for wealth creation strategies.
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