Next, I’d like to discuss one of the fundamental principles of mortgage freedom and building wealth – namely, good debt and bad debt.
Most people think that all debt is bad. Most people have been taught that owing money is not a good thing and we should pay it off as quickly as possible. In most cases that is correct, but a home loan is just a tool, and like any tool it can be used the right and way and the wrong way.
Prudent debt, when used properly and sensibly, is a way to grow personal wealth.
It is this understanding that has made a huge difference in my own path to mortgage freedom.
Bad debt
Simply put, this is debt that costs you money. Most people borrow money to buy things that they use, but that don’t provide them an income, such as a holiday, car (for personal use) and even your home. These are all good things to have, some you would argue are essential to have, but they all take money from you.
Bad debt should be prioritised in order of the interest rate or overall cost of that loan and paid off as quickly as possible.
Based on this definition, your home loan is ‘bad debt’ and therefore should be paid off as quickly as you can – but as you build up equity you can start to turn the asset that is your home into a source of ‘good debt’, which is going to accelerate your journey to mortgage freedom.
Some people think they can avoid major debt by renting and never buying a home. However I would also classify paying rent as a form of bad debt. It is a debt you owe your landlord each month (and all your future landlords).
Key Point: Whether you pay rent or a home loan, you are still paying a large sum of money over your lifetime, but with a home loan you have a house that you own at the end as opposed to helping your landlord pay off their home.
Good debt
This is debt that you have used to buy assets that generate income for you that is greater than the cost of the debt.
Example: what is good debt?
If you borrow money at 6% per annum and you invest in something that pays you 7% per annum, that is ‘good debt’ – because you have made more money than it cost you to borrow.
The interest on good debt is usually tax deductible. Obviously, you need to be conscious of the stability of the income and the asset you have purchased, and obtain any tax and financial advice from a specialist, but the principle is clear. For most people, the safest way to do this is through investing in property, which again should be done with help from experts and after taking the time to thoroughly educate yourself.
The most important thing is to avoid growing your bad debt.
Instead focus on paying it down quickly which will give you the chance to build up good debt over time, which in turn is the income you can then use to boost the speed at which you reduce your bad debt. And then you will have more money for the good things in life!
Unfortunately, whilst most people understand the need to avoid bad debt, they are less informed about the importance of making debt work for you.
Using equity to turn bad debt into good debt
Equity is the difference between the current value of your property and the amount you owe the lender. If you have already paid off some of your home, you have equity because you owe less than the value of the property.