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Loans and Leverages: How to Use Debt to Your Advantage

Loans and Leverages: How to Use Debt to Your Advantage

In recent times, the term 'debt' has acquired a negative reputation; however, it's essential to recognize that not all forms of debt are detrimental. In reality, certain types of debt can be highly beneficial.

Delving deeper, 'good debt' stands as a potent tool to effectively utilize your finances and establish passive income streams, fostering genuine wealth creation. Without the judicious use of debt, owning a home or utilizing substantial earnings to initiate the development of one's financial foundation would be a challenge.

In the following sections, we will explore actionable steps to ensure that your debt becomes a valuable asset, enhancing your financial prospects rather than jeopardizing them.

The Differences between Good Debt and Bad Debt

Understanding the distinction between 'good' debt and 'bad' debt is crucial.

Good Debt involves borrowing for the purpose of acquiring appreciating assets, where the interest on the loan is often tax-deductible. The income generated from these assets can be utilized to repay the debt. Examples of good debt include investments in property, shares, and managed funds.

On the other hand, Bad Debt entails borrowing to purchase items, services, or assets that do not generate income or increase in value. The loan interest, in this case, is not tax-deductible, and there's no revenue from the asset to aid in repaying the debt.

Examples include:

  • Credit card debt – if not repaid within the interest-free period
  • Personal loans to buy cars
  • Most family home loans

Using the Power of Good Debt

You may take a number of actions to set up your finances so that you can begin utilizing good debt to build wealth. Here are the top seven:

1. Debt Consolidation

Managing numerous debts results in excessive payments towards interest and fees. In many cases, a strategic approach, such as consolidating debts by increasing your mortgage, can be advantageous.

By utilizing the additional funds from the increased mortgage to settle inefficient high-interest debts like credit card balances and personal loans, you can optimize your financial situation. While your home loan repayments remain consistent, the lower interest rate on the mortgage enables you to pay off debts with higher interest rates efficiently.

2. Making Your  Savings Work Harder

A common practice for individuals is to maintain funds in a cash savings account for emergencies or as a financial cushion, providing a sense of security. However, a more prudent approach would be to place these funds in an 'offset' account linked to your mortgage.

By doing so, you can achieve a higher after-tax return and simultaneously shorten the duration of your home loan, all without restricting access to the funds.

3. Better Cash-Flow Management

Effectively managing cash flow plays a pivotal role in minimizing undesirable debt. The primary objective is to decrease interest outlays, which is achievable through various strategies.

This includes more frequent payments, or higher payment amounts towards a mortgage, directing your entire salary into an offset account, or leveraging an interest-free period on a credit card to cover daily expenditures.

4. Borrowing To Create Wealth

Utilizing a payday loan online responsibly can provide immediate financial support during unexpected emergencies. However, it's essential to exercise caution and carefully manage repayment to ensure it remains a positive resource in times of need. After successfully reducing undesirable debt, it's essential to initiate the creation of beneficial debt, a strategy known as "gearing."

When approached prudently and with wise investment choices leading to asset appreciation, gearing becomes a powerful tool for wealth generation. The revenue encompasses both income and capital growth from the investment. Thus, covering the debt and surpassing the costs with servicing that debt.

5. Using Lump Sums Wisely

At times, you might come into a substantial lump sum of funds through bonuses, inheritances, or similar avenues. It's prudent to utilize this money to settle undesirable debts or consider making additional contributions towards your superannuation.

6. Debt Recycling

Debt recycling involves leveraging the equity you've amassed in your home as you steadily repay your home loan. This equity is then redrawn to invest in shares or other properties. Thus, effectively transforming what was initially considered lousy debt into good debt.

This newfound good debt has the potential to generate income. This can be utilized to repay the loan while also offering tax advantages. Additionally, any surplus income can be redirected towards accelerating the repayment of your home loan, leading to further interest savings.

7. Invest In A Geared Managed Share Fund

A managed share fund operates as 'internally geared,' eliminating the need for individual investors to secure an investment loan. Despite not personally taking out a loan, investors can still capitalize on the 'gearing' effect achieved through borrowed funds.

In this scenario, the fund manager borrows on behalf of investors at wholesale rates. This means they use the borrowed capital to invest in both international and local share markets.

Bottom Line

While traditional beliefs often view debt as a financial burden, when employed prudently and managed effectively, it can serve as a tool. Thereby, enabling individuals to make purchases that would otherwise be beyond their reach. This, in turn, has the potential to augment their returns substantially.

Investopedia does not offer tax, financial, or investment services or advice. The provided information is not tailored to specific investors' investment objectives, risk tolerance, or financial circumstances. It is presented without such considerations. Investing carries inherent risks, including the potential loss of the invested principal amount.

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