are you financially well organised? Good Debt, Bad Debt Developing an effective Debt Plan

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1 are you financially well organised? Good Debt, Bad Debt Developing an effective Debt Plan

2 Good Debt, Bad Debt In today s society, it is unusual if you do not have some form of debt, it helps us do things that we otherwise could not afford to do with our own funds. However debt comes at a cost and eventually has to be repaid, therefore it is essential that you develop an effective Debt Plan. Most of us at some stage in our lives will incur debt by borrowing from a bank to help buy an asset that we otherwise could not afford to buy with our own funds. The most obvious example is our home. Most people will need to take out a mortgage to help them buy a home, paying off the loan over time out of their employment or business earnings. Interest on a home loan is not tax deductible as the home is not an income-producing asset, so there is no tax relief on the interest charged. Michael Ward Partner FWO Chartered Accountants The same applies for any other loans or credit cards that are taken out to buy non-income producing assets or to pay personal expenses the interest charged is not tax deductible, so there is no tax relief. Conversely, for any borrowings made to acquire an incomeproducing asset such as a business, rental property or shares, the interest charged will be tax deductible against the income derived from the business, property or shares, providing some tax relief on interest charged equal to the tax rate of the owner at that time. Tax deductible debt is sometimes referred to as good debt because there is tax relief applicable to interest charged resulting in a reduced after-tax cost to the borrower. On the other hand, non-tax deductible debt is often referred to as bad debt as it does not offer any tax relief to the borrower. There is nothing wrong with debt as long as it is managed within our means. It must remain within our ability to repay principal and interest over time, from our employment and business earnings. We must take into account funding our various living and other expenses. Having a clear, achievable Debt Plan is an important foundation step in achieving your goals and objectives and being Financially Well Organised.

3 Ensure that you structure your debt so you pay off the bad debt before you start paying off the principal of the good debt. Key elements that should be addressed in your Debt Plan include your choice of loan; a clear repayment plan and the level of exposure your assets are subjected to against the borrowing. Questions you should be asking yourself include what type of loan you should be taking out, the term of the loan and what sort of repayments to make. If you have more than one loan, you should be considering which loan is more advantageous to keep, which one should be paid off first and what collateral is being held against these loans A Debt Plan ensures: The best interest rates and terms have been negotiated on the loan. Do I take out a fixed or variable loan? Interest only or principal and interest repayments? Do I take the loan out over 10, 15 or 25 years? There is no one answer to these questions. It is dependent on the personal circumstances of the individual or entity as the borrower, the current economic conditions, and sometimes what the crystal ball says. But for points 2 and 3 below, there are some very clear strategies that you should consider. A clear action plan has been determined in order to pay the debt off. You should ensure that you structure your debt so you pay off the bad debt (non-deductible debt) before you start paying off the principal of the good debt (tax deductible debt). Sometimes, depending on your circumstances, your debt can be structured in a way so that it becomes tax deductible. The assets exposed to borrowing are limited and only sufficient to support the borrowing as security. Only provide the lender with the minimum amount of assets required to obtain the loan. You don t necessarily have to provide all of your assets as security for a loan. You must take the attitude that your loan security structure is not set and forget. Once you can remove assets from what is required as security by the lender, you should. An example is for business owners who provided their home as security for borrowings made to their business in the early days. Their business has since grown and acquired assets.

4 The loans in the business can sometimes be secured against the business assets on their own so the home is no longer needed as security and should be removed as security. Otherwise, if this is not done and the bank was forced to call up the business loan and needed to sell the home to receive the full loan repayment, a significant amount of equity could be lost. Develop an effective Debt Plan... become financially well organised. For more information on becoming Financially Well Organised contact: Michael Ward Partner FWO Chartered Accountants michael@fwo.net.au (07)

5 Ground Floor, Green Square North Tower 515 St Paul s Terrace, Fortitude Valley QLD 4006 GPO Box 81, Brisbane QLD Ph: Fax: info@fwo.net.au