Using debt effectively

The foundation of using debt effectively is understanding the difference between inefficient debt and efficient debt. From that basis, assuming these are used in conjunction with a responsible wealth creation plan – there are strategies that can significantly improve your financial position and optimise your finances.

When managed properly debt can enable us to purchase items we may otherwise not be able to afford. For example, to buy a house you may not be able to pay for outright – by covering the deposit and then servicing the repayments. Or for example as part of a wealth creation strategy to buy investments with potential to grow in value. This may include property and shares. This strategy, known as gearing, may help you to build an investment portfolio faster than you otherwise could have, in this case using the income generated by your investments to help repay the loan – making servicing an investment loan for many people an achievable outcome.

To understand how to use debt more effectively we are going to look in depth at “inefficient” debt and “efficient” debt.

Inefficient debt

Inefficient debt is used to buy goods, services and assets that don’t generate income and will either depreciate in value or have no value once they are used.

You want to aim to reduce this type of debt as quickly as possible. The reason for this is you can’t claim the loan interest as a tax deduction, you don’t receive any additional income from the asset to help you repay the debt – as such to service the debt you have to rely on your own resources.

Example of this include;

  • Home loans are generally a less efficient form of debt because the home doesn’t produce an income and therefore the loan interest is non-deductible.
  • A personal loan to buy a car is inefficient because the car depreciates in value, it doesn’t generate any income and the interest is not tax deductible.
  • Using a credit card to pay for living expenses is inefficient if it’s not repaid within the interest- free period. This is because the interest on the debt isn’t tax deductible and the things you buy generally have little or no resale value after use.

Efficient Debt

Efficient debt is used to acquire assets that have the potential to grow in value and generate assessable income. You can generally claim the loan interest as a tax deduction and use the income generated by the asset to help repay the debt making it more easily serviceable. “Efficient debt” is generally used to accelerate the creation of wealth.

Examples of this include;

  • Using an investment loan to acquire an investment asset, like property or shares (either directly or via a managed fund). This is efficient because the asset has potential to appreciate in value, it generates income and the interest in the loan is generally tax deductible.

Anthony Landahl | Equilibria Finance

This is for general information purposes only and does not constitute advice. With all of these options there are a number of considerations outside the scope of what is covered in this article that you need to understand to ensure your personal circumstances are taken into consideration.

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