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Good Debt or Bad..It All Needs To Be Repaid

Earlier this year, the Australian government got involved in a bit of a debt shell game. Rather than label all debt as, well, debt, the government reclassified its overspending habits. We now have ‘good’ overspending and ‘bad’ overspending.

Spending on infrastructure projects, for example, is considered good debt. The idea being that over time these projects will create enough economic growth to more than pay for themselves, atop the interest payments.

Bad debt falls into spending on recurrent needs, like public services and welfare payments.

Now, there is some merit to this idea.

If you think about your own household or business, good debt might be taking out a $40,000 loan on a new work ute. It’s a hefty loan, but you put the ute to good use and earn $20,000 per year more than you could have without it. That’s more than enough to cover your interest payments and repay the principal within a few years. At the end of which you’re debt free and still have a working ute earning you extra income.

You can think of bad debt as taking out the same loan for the same ute…only you just drive it around to impress your friends. Now you need to repay the hefty loan and interest without earning any extra income. And you’re doing so on a depreciating asset. Let’s say it takes you five years to pay off the loan, plus the $10,000 or so in interest over that time. You’re now out $50,000 for a five-year-old ute worth around $20,000.

But in most cases, distinguishing between ‘good’ debt and ‘bad’ debt can get a lot murkier…fast.

Take housing for example. Property prices in most of Australia’s capital cities are at (or near) record levels. And it’s driving Aussies into record levels of debt.

From Domain:

With cash interest rates at a record low and house prices near record highs, the nation’s household debt-to-income ratio has climbed to an all-time peak of 189 per cent, according to the Reserve Bank of Australia.

That means there are an increasing number of people who have little cash for discretionary spending – on everything from cars to electrical appliances and new clothes – as their pay packets get consumed by large mortgages and high rental payments in the country’s red-hot property market.

So long as house prices keep going up, you could consider this ‘good’ debt. The capital growth will allow you to sell at any time, pay off your debt, and walk away with a profit. Of course, when house prices fall (and they will eventually), your good debt will be looking pretty darn bad.

The key then, to distinguishing between good and bad debt in property, is all in the timing.

The same holds true for government spending. Borrowing huge sums for poorly planned and poorly timed infrastructure projects isn’t going to return anything…except losses to you, the taxpayer.

As a Markets & Money reader, it likely won’t come as any surprise to you that the Australian government is quite good at getting the spending targets wrong. At least when it comes to growing the economy. From ABC News:

Research compiled by big investment bank Morgan Stanley has found that while China is using around $6 of debt to create $1 of GDP (Gross Domestic Product), Australia is using $9 for the same dollar of growth.’

With federal government debt surpassing $500 billion this month, I’d think twice before labelling any of that as ‘good’ debt.

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