In current market scenario where net wealth of clients is being eroded due to unforeseen factors like the corona virus crisis, it is important we understand how to manage our future wealth and help mitigate the blow as far as possible.
There are ways we can work in normal market situations when jobs and incomes are not impacted. However, these are desperate situations and as they say desperate times warrant desperate measures. Traditionally tax minimisation and strategic investments work well when we are earning good income and have savings to invest in well structures investment portfolios. With the market meltdown that we have had, clients have lost almost 15 % to 20 % of their wealth in superannuation and other investment funds in the last three months. In these times staying in cash is probably the best one can do as these markets will keep swinging like a pendulum and hence cause a lot of grief.
Probably the only aspect of wealth creation that to a great extent is within our control is to assess our current debt situation and ascertain if there are ways to reduce our current debt.
It makes sense as with current interest rates being the lowest in history, we need to see if there are possibilities to replace those higher paying debts on our credit cards at say 18% and personal loan debts at say 10% with cheaper loans or maybe eliminate them completely
In order to understand debt, it is important to understand the debt reduction cycle as shown below.
DEBT REDUCTION CYCLE
Most clients struggle to understand the concept of what good debt is and what is bad debt. The very fact that this distinction exists intrigues many. Let us understand this in simple terms.
Good Debt – Any loan that you take that is generating an income for you and in the course of generating that income allows you to claim a tax deduction for the interest that you pay on the loan is considered a good debt .
So, Debts on your investment property, margin loans on shares, investment warrants and business loans are considered good debts because the interest paid is deductable against those corresponding incomes.
Traditionally businesses, investors and investment property owners have thrived and accumulated a lot of wealth purely by borrowing money against their income generating work horses so that they could claim deductions on the interest and grow their wealth purely by leverage.
Bad Debt - Any loan that you take on your personal account is not tax deductable and is considered bad. These are debts like personal loans, credit cards, owner occupied property loans and lay buy purchases. So technically these are bad and should be completely avoided as you need to pay them off with your after-tax money.
In simple terms what needs to be done as part of the debt reduction cycle is to reduce your bad debt. This can be done in many ways and must be implemented only after considering the personal circumstances of the client. However, it could be the following:
a) Pay off your high interest credit cards by your cash savings or reduce them by replacing it with lower interest paying personal loans or credit cards.
b) Debt consolidation is again a great strategy where you can consolidate all your debts and go to personal loan provider to borrow at a cheaper rate of interest. This is possible with some companies that offer auction loans where rates can be as low as 8 to 10%.
c) Refinancing your home loan can be a great strategy. As you may be having a home loan that was financed a few years back and given the current low rates, it’s possible to reduce your rates by as much as .25 % to .50%. Also, there may be a situation that you have some equity in your home loan that can be financed at 3 % - 3.25%. Why not use the cheap funds to pay off your higher interest-bearing credit card and personal loans?
d) Good Debt in normal market conditions is a good strategy but given these adverse times it is not a good idea. Since good debt works on the premises that there is an income that will be generated from it and a tax deduction can be claimed, that can change if one loses their job and source of income. So technically in that situation a good debt will become a bad debt.
Tax Minimisation: The only reason why good debt is encouraged is that it can potentially save you taxes and with those savings you could pay down the bad debts.
In many situations’ clients have no option but take on additional good debt, as they want a tax deduction against their otherwise high incomes and higher taxes. By claiming these deductions and getting a tax refund from ATO, they could use those for anything including paying down their loans.
One strategy that works on the principle of tax minimisation is “negative gearing”. In negative gearing you have a situation where your rented property expenses plus depreciation is more that the rental income. This “negative “amount can be set off as a deduction against all your other incomes. That creates a cash saving in many cases and hence can be used to pay down your bad debts like home loan. So, this is a situation where your good debt (investment loan) will pay down your bad debt (home loan)
So in principal we always need to bring down our bad debt by either paying it down by personal savings, tax savings( good debt) or cheaper debts .If we cannot eliminate our debts , we can certainly work towards reducing it and mitigating the blow.
DID YOU KNOW?
* If you had a home loan of $ 500,000 at interest of 3.25%, you would pay a monthly of $ 2,250 on a loan of the tenure of 30 years. If you increased your monthly payment by $ 1,000, your tenure of the loan can be brought down to 17 years.
* Fortnightly repayments of home loan (instead of saying monthly) help you make extra mortgage payments every year and could save about 5 years off a 30-year loan at today’s rates.
* During the first seven years of a 30-year mortgage approximately 80 percent of the total in loan payments will be for interest and only 20 percent of the payments go to principal. So practically even after 7 years of your loan, you have mainly paid down interest.
All these facts suggest that if we work towards paying down our debt early, we can achieve financial freedom.
There are small things that can be done to achieve better results if we are conscious about our financial situation and want to create wealth over a period.
You should consult a financial advisor to help you create a road map / action plan to achieve your financial objectives.
• Author: Vic Singh, CA, ADFP – Virtual CFO, Chartered Accountant and Financial Planner, helping business clients with their business advisory services and setting up systems for improving their profitability, productivity and financial efficiency.
