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Posted November 20, 2018 by MoneyLink

Who Is Afraid of Debt?

Some people are afraid of debt and shouldn’t be. Others aren’t afraid of debt and should be. We have heard the saying “debt is a good servant but a bad master”. It pays to have a clear understanding of how to use debt for good and how to avoid its potential traps.

When thinking of borrowing money there are several criteria we should consider before acting. The most obvious one is the interest rate. Clearly if the cost of the loan is 15 or 20 per cent that is a strong warning signal.

If we are borrowing on credit cards or personal loans at those rates it should be a small amount of money and a short period of time. However a loan at around five per cent may be smart, depending on circumstances.

An important consideration is whether the interest cost will be tax deductible or not. If it will be and our taxable income is medium to high, that will reduce our net interest cost greatly. Expenses incurred in earning income are usually tax deductible.

Borrowing money to earn income

If we borrow to buy something that will help us earn income or be used in a business the interest should be deductible. If we are in the 39 per cent tax bracket a loan at six per cent will only cost us about 3.6 per cent after the deduction.

What we borrow the money for is a key issue. If it is to buy depreciating assets such as consumer goods that is another caution signal. A new television or lounge suite, or a holiday will be worth very little in a few years.

We don’t want to be paying off a loan for them at a high interest rate after they have passed their use-by date. If we want such things we should seek a low-cost loan or second hand items, or defer the purchase until we can afford to pay cash.

However, borrowing to buy assets that will increase in value could be a smart move. If we plan to purchase a property, farm or business that is a positive. If we borrow to buy managed funds or shares that is also a tick.

Can you afford the loan?

Before taking up a loan we must be sure we can afford the payments and pay it off. Obviously having a high income helps. If our income is low we should consider the regular payments carefully in our household budget.

We all need a house to live in and comforts, and homes are expensive and loans not deductible. It is essential to seek a low-cost home loan. If we must borrow for cars we should keep the purchase price down and the interest low.

Debt can be a good servant

Debt can be a great servant when the interest cost is low, we buy a business or investment that will appreciate in value, and the interest is tax deductible. Many people who build up large portfolios of properties, shares or managed funds use borrowings to do it.

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