DebtSmart Options

Making the right financial decisions is not always easy. Having a good understanding of financial concepts can make the decision making process much easier because you have the confidence that comes with knowledge.

We have included below a few basics to give you the confidence to make the right decision for you.
Good Debt vs Bad Debt. Some types of debt are good and others are bad, with some being very bad indeed. Good debt can be described as a debt that is used to purchase assets that will one day produce income for you and also appreciate in value. Good debt also has the added benefit of the interest component being tax deductible.

Bad debt can be described as debt that is used to items that will not produce income for you, and the interest is not tax deductible. Most people would know that credit card debt is bad but using our definition of bad debt, your home loan could also be considered as a bad debt.

Not convinced? Your home may go up in value but will it ever produce income?

Often we can find ourselves in a position where we have accumulated a number of loans from different organisations. These debts can be a combination of home loans, personal loans, credit cards, and store cards.

If you have a number of different loans from different providers you are certain to also be paying different rates of interest and also have different loan terms. Apart from the nuisance of having multiple payments at different times of the month this arrangement can be financially damaging.

Consolidating these debts can be one strategy to get on top of your debts, free up additional cash flow, and simplify your financial affairs.

Here’s how it works:

Let’s imagine that a young family has a home loan and a number of debts, as outlined in the table below:

To save on interest and use debt more efficiently, the young family increases their home loan from
$350,000 to $380,000 and use the additional $30,000 to pay off their car loan and credit card.

This means the home loan interest rate of 6.5% will apply to all their debts and the total minimum
repayment will reduce to $2,565.79 – a cashflow saving of $358.90 in the first month alone.

But rather than spending this extra cash, they will continue to pay $2,924.69 into the consolidated loan each month until their home loan is repaid. This allows them to pay off their debts sooner and save $111,058 in interest.

If you have a number of different debts with some interest rates higher than others it can be helpful to consolidate your debts (see above). Sometimes, however, it may not be possible to consolidate those debts due to a poor credit history or not having enough equity in your home to consolidate those debts into your home loan.

In instances such as these it can be worthwhile prioritising your debts. Simply, this means developing a budget and making higher repayments to the debt which has the highest interest rate.

Since interest on most loans and credit cards is calculated daily, making higher or additional repayments to the debt with the highest interest rate gives you the most ‘bang for your buck’.

Remember, with all other things being equal, you shouldn’t prioritise the debt or loan with the highest balance because even though the balance may be high it is the interest saved on the portion repaid that gives you the benefit.

For example, you may have a home loan for $350,000 at 6.5% per annum and a credit card with a balance outstanding of $2,000 at 18% per annum. Given the choice between making an additional repayment of $1,000 to either your home loan or credit card, you will save more interest by repaying the credit card since the interest rate is higher. The relative size of the home loan compared to the credit card is of no consequence in this type of scenario.  

Simple Interest vs Compounding

When you combine regular savings with compounding you can get some surprising results. Once again it's probably easiest if you look at an example. Let's imagine there are two brothers. One starts a regular savings plan with $200 per month in an investment earning 8% per annum with all returns reinvested and compounding.

Over the course of a twenty year period the total contribution made into the investment is $48,000. The second brother starts later, in year 10. Because he starts later he decides to play catch up and invest $400 per month for the next 10 years into the same investment, with the same returns.

At the end of the period both brothers have invested a total of $48,000 into their investment. Let's look at the end results.

Dollar cost averaging is a concept where you invest a similar amount on a regular basis (monthly, quarterly, yearly etc) into a share or managed fund investment where you are buying shares or units that can fluctuate in value.

Dollar cost averaging takes advantage, or reduces the risk, of market volatility. By investing smaller amounts on a regular basis you can 'average out' the cost of each purchase as well as avoid the risk of investing a large chunk at the top of the market.

It's probably easiest to view an example of how it could work. Let's imagine you are investing a regular sum of $1,000 per month into a regular share based managed fund and the share market falls. 

As you can see, volatility can actually work for you as you buy more units when the value of your investment falls. Of course, the reverse is true if the market rises because as the price rises you pick up fewer units or shares.

No one can tell for certain in advance whether a large lump sum investment would be better than dollar cost averaging but if you're nervous about markets this can help ease those nerves. A Dollar Cost Averaging calculator is available the Tools and Calculators section of this website.

When you buy a house with borrowed funds the bank is lending someone else's savings to you, which are then 'stored' in your house. As you begin to repay that loan you are, in effect, incrementally replacing that other persons savings with your own. If you have additional funds available you have a few choices. You can spend or consume the additional funds, repay your home loan, or invest.

Let's put aside the 'consume' option and consider how the other options affect your net worth. That is,
what is the net effect of undertaking these options?

Firstly let's consider a simple method of how to calculate net worth using an imaginary couple.
For simplicity we'll exclude super and any other personal effects;

Paying off the home loan decreases their 'bad' debt and leaves them with a net worth of $300,000.
The only problem: they have no investments that can take advantage of compounding. Investing the proceeds gives them the benefit of accumulating funds that can benefit from compounding. Unfortunately they still have 'bad' debt.

In the third scenario ‘Do Both’ we have repaid $50,000 from the 'bad' debt, therefore creating an additional $50,000 in available equity. We have then created a 'good' debt using this newly created equity to make an investment. This is good as the couple now have funds invested to take advantage of compounding.

As can be seen the net effect at the time the transactions are made is the same across all three scenarios. Does this mean that you would be better off over the long term if you did the same as our imaginary couple?

That all depends on a number of factors including things like interest rates, marginal tax rates, investment returns, your time horizon, and more. Your financial planner can help answer that question for you. But you may want to ask yourself: If the above is true with $50,000 is it also true with $500? If it is true as a one off event, would it not also be true monthly or yearly?

A dividend is the part of the earnings from a company that is paid to the company's shareholders. For companies listed on the Australian Stock Exchange this is normally paid two times a year. The dividend you receive is based on how many shares you hold and is normally expressed in 'cents per share'. Example: A company with a share price of $1.00 may declare a dividend of 5c per share.

Companies do not have to pay dividends; they can choose to reinvest their profits to grow their future revenue. In practice most companies will retain some of their profits to reinvest, and pay a dividend as well.

Companies pay tax on their profits at a flat rate of 30%. In many cases when you receive your dividend you will also receive a credit for company tax already paid. This is called a 'franking credit'. In some instances dividends are paid without a credit, these are called 'unfranked dividends'. In your dividend statement you will receive details of how much of your dividend is franked and how much isn’t.

The benefit of receiving income through dividends with franking credits attached is that your personal income tax liability on the income earned is less than it otherwise would be, since company tax has already been paid on the profits before the dividend was paid. In this way any profits from the company are only taxed once, not twice.

Let's have a look at an example of a franked dividend and how this type of income is taxed differently to income without franking credits, such as rental income. John receives a fully franked dividend from XYZ Ltd of $700 with a franking credit of $300.

John's total assessable dividend income is $1,000 ($700+$300). If John earns a salary of $40,000 a year, and his dividend income is his only other income received, then his total taxable income is $40,000 + $1,000 = $41,000. At 2009/2010 income tax rates John's tax on that income would be $6,150 but that is offset by his $300 franking credit, reducing his final tax payable for the year to $5,850.

The tax benefits vary according to your Marginal Tax Rate (MTR). As a guide, if your MTR is below the company tax rate then you will receive a refund for some of the company tax paid, whereas if your MTR is above the company tax rate then you will only pay the difference between your tax rate and the company tax rate.

Investments generally have two types of returns, income return and capital return. Interest, rent, and dividends are an example of income returns. The capital return is the underlying value of the investment be it a term deposit, investment property, share or managed fund portfolio.

The capital value of a term deposit doesn't change over time whereas the value of shares and property can, and will, change over time. A growth income stream is where the income return from an investment has a relationship to the value of the underlying capital value, both of which can grow over time. The relationship may not be constant or exact but it does exist nonetheless.

Whilst some investment assets can grow in value and others have an income return related to the value, only some types of assets display both characteristics. 

Australian shares are a good example of this. Let’s take a look at Woolworths as an example, since it is a relatively easy business to understand. Woolworths is a retailer of groceries, alcohol, electrical goods and more. Over many years Woolworths has generally made a profit. As noted above in the ‘Dividend and Franking Credit’ section Woolworths will pay some of their profits to their owners (shareholders) as a dividend but also retain some of those profits to reinvest back into their business.

The money invested back into the business will be used to build more supermarkets, liquor stores etc in the hope of increasing their future sales and therefore their future profits. They would also invest in new technologies, systems, and processes to improve the efficiency of their stores and businesses. If, as has been the case, their profits grow over time then so will the value of dividends paid to their owners (shareholders).

That is, as a part owner of Woolworths you would have received a growing stream of income as their profits have grown. Below is an illustration of how both the income and capital value of a $100,000 investment made in Woolworths in 2000 would have paid a growing income stream (dividend).

As can be seen there is a relationship between the underlying value of Woolworths shares and the income they generate both of which have grown over time. We are not suggesting you invest in Woolworths as past returns are no guarantee of future returns and it is wise to diversify your portfolio across more than one company. However, this does quite neatly illustrate the concept of a Growth Income Stream.

Residential property has many positive characteristics such as long term capital growth and a perceived lack of volatility but it is not a growth income stream asset. This is because the income return (rent) is not related to the capital value but the underlying supply and demand of rental properties. You may be lucky enough for your property to rise in value but that does not necessarily mean that the rent will rise in line with the increase in value.

Gearing can be simply defined as borrowing for the purpose of investment. The investment could be in property, shares or an investment portfolio.

The benefits of gearing are that investors are given the opportunity to:

• make larger investments than would be possible if the investors were using only their own funds;
• reduce their tax liability as the costs associated with gearing are generally deductible against
  income from the investment and other taxable income received by the investor; and
• achieve higher returns than could be achieved without gearing, after allowing for tax and
  all costs associated with gearing.

However it can be a double-edged sword. If the investment performs badly, the investor's losses are multiplied instead. The cost of borrowing funds compared to the amount of income received from the geared investment creates three levels of gearing: Positive, Neutral and Negative.

Positive gearing is where the cash flow received from investments exceeds the borrowing cost of the investment. As the earned income exceeds the deductions on interest, the investor may have to pay income tax on the additional earnings.

Neutral gearing occurs where the investment income is equal to the cost of borrowing. In this case, there is no tax advantage and because there is no additional income received, no additional income tax needs to be paid.

Negative gearing is where the cost of borrowing exceeds the income generated by the investment. The excess costs can generally be deducted from other income received, but the investor will still be out of pocket as the tax deduction will not cover the whole amount of the income lost. A negative gearing strategy is normally undertaken where it is expected that the underlying investment will provide sufficient capital gain to compensate for the income loss. The success of a negative gearing investment strategy, thus depends on the investor earning a sufficient capital gain (after capital gains tax) to offset the after-tax investment income losses.

Example. John's annual salary is $40,000.  With the positively geared investment he has borrowed $10,000 to add to $15,000 of his own funds.  Under the negatively geared investment he borrowed $25,000 to add to his own $15,000.  Assuming that the investment income rate is 3% p.a., investment growth rate is 5% p.a. and the cost of borrowing is 8% p.a., then:

As illustrated in the above examples, negative gearing reduces taxable income and after-tax income. If gearing an investment increases the return to the investor, then negative gearing which increases the investor's exposure will increase the return further, however, gearing also increases the losses for poor investments.

Debt recycling is a strategy that helps you build wealth by incrementally replacing bad debt with good debt to build investments and wealth. When managed properly debt recycling has a number of benefits. With debt recycling it is possible to:

• Rapidly repay your home loan
• Build investments as you repay your home loan, and
• Reduce your annual tax bill

Debt recycling works by combining the power of compounding, regular savings, and gearing, with the
added benefit of being able to access the franking credit system, if implemented correctly, for even greater tax efficiency (see Dividends and Franking Credits above).

Debt recycling can be a lower risk strategy to unlock your home equity and build investments as you can start with smaller amounts. This way your cash flow is not impacted in the way it would be if you were borrowing large amounts to invest, say for an investment property. 

Debt recycling works best when the investments in your portfolio have the Growth Income Stream
characteristics (see above). Contact your financial planner so they can explain how debt recycling works and whether it is strategy that you should consider.