How Bad Debt Will Stop You Dead in Your Tracks

One of the most common ‘stuff ups’ that property investors make is to take on too much bad debt. Too much bad debt stifles any opportunity to invest.

By bad debt I mean debt that is not income producing and/or attracts interest that is not tax deductible. Typically bad debt includes credit card, own home mortgage and personal loan debt. When it comes applying for a new loan to buy an investment property the amount of your income that is used to service the bad debt is deducted from the income used to calculate the amount that you can borrow. The end effect is that your borrowing capacity will be diminished by your bad debt, how much will depend on the level of the bad debt.

The message is simple and straight, how do you expect the banks to lend you money to build a property portfolio if all you have is a stack of credit card bills, personal loans and a massive mortgage for your dream home?

What I struggle to understand is how people can go and borrow all that they can on their own home and then leave nothing for any future investments. They max their bad debt, make minimum repayments each month on their bad debt and then wonder why the banks won’t lend them any more money to buy an investment property.

I understand that we have been raised in a society where borrowing money is an acceptable practice – especially bad debt and it seems that this attitude is being passed on from generation to generation. Our most fashionable generation, Gen Y has the attitude that they must have it all now and that tomorrow will take care of itself. Tomorrow is too far away for them to think about and this attitude has given rise to the many bad debt borrowing schemes that allow them to borrow interest free for periods of upto four years. Statistically, most do not end up paying by the due date and end up paying exorbitant interest rates as a result.

Bad debt is what keeps you in the day job longer. If you have visualised retiring at an early age, laying back on a deck chair, enjoying life and playing the regular game of golf or having lunch with friends, then keep bad debt out of your investing equation.

A typical scenario is one where a couple (Bob and Anne) earn an average income, have a $450,000 mortgage on their own home, have credit card debt of around $20,000 and a personal loan or car lease for about the same. They want to buy an investment property and to their utter disappointment find out that the banks won’t lend them any more money and they don’t know why. Can anyone seriously blame the banks for not lending them anymore? Of course you can’t, with nearly half a million dollars of bad debt, the risk is a high one for the banks to take on. If Bob and Anne both lost their jobs they wouldn’t be able to pay the interest on their loans and would have to default on them. If the situation continues to long it could potentially lead them down the path of bankruptcy. The interest on the credit cards, personal loans and an owner occupied mortgage on a $450,000 house all add up. People simply don’t realise the impact that bad debt has on their capacity to borrow more.

The key to a wealthier, earlier retirement is no bad debt and lots of good debt. Good debt is debt that earns an income and/or attracts interest that is tax deductible. Investment properties provide income through rent and the ATO allows owners of investment properties to offset the property expenses against their own earned income and the income from the property. This effectively allows investors to pay less tax than they would normally have to. The added bonus that creates real wealth is the capital growth in the property as it appreciates in value over the years. Repeat this process in a balanced way a few times and the results are truly magnificent.

On a personal level, I have experienced the magnificent power of good debt and the adverse negative impact of bad debt and I know which I prefer. I spent my youth working hard for the money to pay off credit cards and personal loans for things I didn’t really need but being an impulse shopper I made it a weekly ritual to peruse the shop windows in case there was something I just had to have.

If I had my time over again, I would have saved more of my income and put it towards income producing assets which would have then have allowed me more opportunity to do the things that I really wanted to do as I grew older. I still like my retail therapy but these days it’s based on reward for effort in accumulating more wealth rather than having to have it now.

Until next time, happy investing.

Helen Collier-Kogtevs Investor and Author of 47 Biggest Mistakes Made by Property Investors and How to Avoid Them. http://www.realwealthaustralia.com.au