Debt reduction vs Wealth creation

Equability of stones

One of the major road blocks to building wealth for the future is carrying too much debt…or more specifically, carrying too much bad debt.

Many advisers and accountants have varying opinions as to what is good debt and bad debt. For instance many say good debt is tax deductible debt and bad debt is non-tax deductible debt. I don’t necessarily agree with this. By this definition a loan on every investment property would be good debt. But what if the property purchased was a rubbish property – such as a small apartment in a high rise apartment building that the “investor” paid too much for and is never going to grow in value? The loan may be tax deductible…so called “good debt”, but the property may not be worth any more in 10 years time than what it is now. I certainly wouldn’t consider this to be good debt…let alone a good investment.

On the flip side of this, I wouldn’t consider debt that has been used to buy a decent home in a good area to be “bad debt”. Sure it may not be tax deductible…but this asset is likely to be a foundation of your wealth creation plans as you strive to fuel your family’s future. This is of course providing that you haven’t tried to keep up with the Jones’ – or your best friends – and bought a house you can’t afford resulting in no cash flow being available to fund your wealth creation journey…it all comes back to cash flow.

My personal definition of good debt and bad debt is “good debt helps you build long term wealth (provided it’s affordable) – while bad debt erodes your ability to build wealth”.

By this definition tax deductible debt on a rubbish investment property is bad debt, as is the personal debt that is the biggest contributor to Generation X & Y not being in a position to build wealth…credit card debt.

Too often over the years I have met with well meaning, hard working people that have dug themselves a massive hole by racking up obscene amounts of credit card debt that is suffocating them. Being drawn in by easy access to money through credit cards, and then spending to their limit, is the major reason why many Gen X & Gen Y will not achieve future financial freedom. It’s also the major reason why many Gen X & Gen Y go bankrupt. I read somewhere recently that most people who declare bankruptcy is not due to a massive mortgage, but quite often due to credit card debt for less than $20,000 – but has become impossible to pay off.

If you are reading this, then I think it’s fair to assume that one of your goals is to create future financial freedom. If this is a goal, then do yourself a favour and rid yourself of the reliance of credit cards to help fund your cost of living. You don’t need them. If you really “must” have a credit card then keep the limit to $1,000. Alternatively, have a Debit card and only spend your own money, not the banks money. Even if you feel you manage money well, don’t fall into the trap that I did in my late 20’s by having a $15,000 credit card limit – just because the bank offers it to you. No matter what the limit, 99% of the time, credit cards will eventually be at their limit. If your credit card limit is currently $15,000, chances are you will eventually owe $15,000. It’s amazing how an overseas holiday suddenly becomes a preferred travel option when you have a $15,000 credit card limit – when an alternative holiday within Australia for 1/5 of the price would have been just as suitable. Reduce your limit to $1,000. This is a form of “taking money off yourself”…if it’s not there you can’t spend it.

But what if you currently have credit card debt that you are struggling to pay down? Chances are one of the reasons you might be struggling to pay it down is because it’s still active and you are still using it.

Step 1Cut up the card. If this scares you then as above set up a 2nd card with a $1,000 limit. But cut this current card up…now. You will never pay it down if you can still use it. Everything you pay off will eventually be spent and you’ll be in the same position you are in right now. Cut up the card…seriously.

Step 2 – Consider transferring the credit card balance (or “balances” if you have multiple cards) to a credit card with a 0% introductory rate (for 12 – 18 months) on balance transfers. This will ensure that what you pay off the card actually comes off the balance rather than just service interest payments. But when the new credit card provider sends you the new card – refer back to Step 1…cut up the new card as well.

Step 3 – Decide on a specific date that you want to have the credit card balance paid off by.

Step 4 – Based on Step 3, break the amount you owe down into a monthly payment (assuming you are paid monthly) and by implementing the “Bottom up Budgeting” lessons covered in Wealth Creation for Gen X – Introduction Part 2 pay this amount first every month on pay day just like your mortgage or your rent. Importantly, as you pay down the credit card, contact the bank every month and instruct them to reduce the limit to the new amount owing – this will take away any temptation you may have to access the amounts you’ve paid down. Once again, if it’s not there you can’t spend it!

For example if you currently owe $6,000 on a credit card that you are struggling to pay off, but you would like to pay off in 12 months time – then immediately cut up the card (you’ll thank me one day), consider transferring this to a 12 month Nil interest rate card, and resolve to pay $500 per month off this as soon as you get paid every month. Automate the transfer via internet banking so you don’t have to think about. Instruct the bank each month to reduce the limit to the new amount owing. In 12 months you would have paid off the card and importantly you would now be in the habit of “taking this money off yourself” and suddenly this $500 per month is available for wealth creation rather than bad debt reduction.

As I will cover further in future blogs, taking on debt is an important part of Gen X & Gen building wealth for the future. But it needs to be good debt, not bad debt. In my mind good debt is essentially debt that is used to buy good quality assets that are likely to grow strongly over time – whether this be your home, a quality investment property in a good location, a diversified mix of blue chip shares, or even a business.

However I do think it’s crucial to be building wealth and reducing debt in tandem with one another…even if you currently have a high maxed out credit card debt. Saving money and building wealth feels good mentally and emotionally. Being solely focused on reducing bad debt doesn’t feel good. Importantly, saving money creates momentum as well as good habits.

The same applies to those Gen Xer’s who might be in a good cash flow position and be focused on reducing their home mortgage. If this is you then you might ask, “why shouldn’t I keep doing this?”. The challenge with this is that you need to live somewhere and your home won’t produce you an income in the future. I’m a big advocate for reducing your home mortgage because once again it feels good…and it’s a risk free return. But as we’ll cover next week, it’s important to be doing this is tandem with an appropriate wealth creation strategy to build multiple income streams in order to create future financial freedom.

But for now if you are one of the many Gen X & Gen Y who have let your credit cards get out of control, then immediately start to follow the above 4 steps to rid yourself of credit card debt forever. This will be the turning point on your future wealth creation journey.

Matthew Morrison is the Director of Wealth Advisory at The Practice, a Personal Wealth Advisory & Business Advisory firm based in Parkville, Melbourne. Matt along with The Practice team are committed to and passionate about developing & implementing wealth creation strategies for clients to enable them to Fuel their Family’s Future (while protecting them along the journey).

Matt and The Practice team can be contacted via http://thepractice.com.au or (03) 8888 4000.

Disclaimer – the above views are general advice only and are purely the opinions of the author. It’s important that you seek personal advice & guidance based on your individual circumstances.

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