No one likes the feeling of being in debt, but in this life, getting into some debt is all but unavoidable.
Far from always being a bad thing, however, going into debt can be useful, and, as we’ll discuss, it can even help you build wealth.
To give you a better grasp on this topic, let’s spend some time looking at productive vs. unproductive debt, common loan terminology and the different types of loans you can get. Lastly, we’ll go over some red flags to watch out for as you secure a loan.
Wealth creating vs. wealth depreciating debt
There may be lots of different types of debt, but from an investment point of view there are only two: wealth creating and wealth depreciating.
For example, let’s say you borrow some money to invest with a 10% rate of return. Eventually, you’d make enough to pay back your debt, and borrowing money in the short-term would lead to higher returns in the long-term. This is known as wealth creating, or efficient, debt.
On the other hand, let’s say you go into debt to buy a car. While this may be a necessary purchase, the car is only going to depreciate as time goes by, so you can’t expect to make money off the debt. The same would apply to most things you buy with a credit card. This is known as wealth depreciating, or inefficient, debt.
Wealth creating debt means that the asset you acquired through the debt:
- Will generate assessable income you can use to pay off the debt
- Has the potential to grow in value
- Has an interest cost you can claim as a tax deduction
Wealth depreciating debt means that the asset you acquired:
- Will not generate assessable income
- Will depreciate in value
- Is not tax-deductible
While some wealth depreciating debts are unavoidable, it’s sound financial practice to try and reduce these wherever you can.
Learn more about using debt to build wealth.
Loan terminology: words to know
Before we get deeper into the business of loans, let’s review a few terms that will help you better understand what we’re going to talk about:
- Principal balance
Your principal balance is the main loan amount, before interest and other fees have been added on. If your loan is fully paid off, the principal balance will be $0.
- Interest rate
Your interest rate is what the lender charges you for borrowing money, and is a percentage of your principal balance. How high or low your interest rate is depends on the loan length, risk, inflation, and sometimes your own credit score. A fixed interest rate stays the same throughout your loan, whereas a variable interest rate may change depending on market conditions and other factors.
- Annual Percentage Rate (APR)
APR calculates how much the interest on a loan adds up to for an entire year, which is why it’s called an annual percentage rate. It may include other costs as well, such as loan fees, but basically it tells you how much a loan will cost you per year.
- Collateral
Collateral refers to something you use to secure a loan, such as property, vehicles, equipment or jewellery. If you fail to pay the full loan back, your lender can seize your collateral and sell it to make up for their loss. A loan that requires collateral is known as a secured loan, while a loan that doesn’t is unsecured.
Types of loans
With any loan, there are five key things to consider:
- Purpose: what will the money be used for?
- Interest: how much interest will you have to pay?
- Fixed or variable: will your interest remain fixed at one number, or will it fluctuate throughout the length of the loan?
- Secured or unsecured: is the loan secured against an asset, allowing the lender to take possession of that asset if you can’t repay the loan in full?
- Term: how long do you have to pay back the full amount of the loan?
Let’s go over some of the most common types of loans.
- Credit card
Credit cards are one of the most popular loan types, probably because they’re generally easier to get a hold of. If you pay your full credit card balance by the due date, you won’t incur any interest. But if you don’t, you’ll be charged interest every month until it’s completely paid off. In Australia, the average credit card interest rate is around 19%.
So if you made a $2000 purchase on a credit card with a 19% interest rate and didn’t pay any of the balance by the due date, you’d be charged $380 in interest. The next month, if you still hadn’t paid anything, you’d have a balance of $2380 and be charged $452.20 in interest. For this reason, it’s best to pay as much of your balance as you can by the due date, even if you can’t pay it in full.
- Car loan
If you’re buying a car, you can take out a car loan from a bank or other financial institution. With this method, the bank gives you the money as a lump sum, which you use to buy the car. Then, over time—usually in monthly instalments over the course of three to five years—you pay back the full amount plus interest. You can also get a loan from the car dealer, but they tend to charge higher interest rates.
- Personal loan
You can get a personal loan from a bank and repay it over a period of two to five years.
This may be the best option for someone who needs to borrow a small amount of money, has a good credit score, and is confident they can pay it back within a couple years.
While you won’t need collateral for this type of loan, you will need to provide income verification and proof that you own assets at least as high in value as the amount you’re borrowing, which is typically a few hundred to a few thousand dollars.
- Mortgage
A mortgage is a type of loan agreement made between a lender and a buyer to pay for a house. As the buyer, you put a downpayment on the house (usually 20%), then pay the rest of the cost over a period of 20-30 years. You’re paying this money to a lender, who has already paid the full cost of the house.
With a mortgage, you pay a principal amount plus interest. For example, let’s say you buy a house for $700,000 and give a 20% downpayment of $140,000. You would still owe $560,000: that’s your principal.
On top of that, you’ll be charged interest. Usually, mortgages will start with a fixed interest rate, then move to a variable one after five years. This means your rate may fluctuate from month to month. The average mortgage interest rate in Australia is 5.89%.
Learn more about how to choose and apply for a mortgage.
- Margin loan
A margin loan is a secured loan (meaning it’s backed by your collateral) you can use to borrow money to invest. In this case, the collateral you use is your investment. Both the investments you use as collateral and the investments you purchase will need to be on your lender’s approved securities list (ASL).
Each investment on the ASL has a loan-to-value ratio (LVR), which states the maximum amount you can borrow against it. If the equity, or value, of an investment falls below the margin set by your lender, your LVR may increase, in which case you’ll need to give the lender more cash to keep the LVR under the maximum. If you can’t provide this cash, the lender can sell your investment.
For example, let’s say you bought $100,000 in shares through a margin loan, and the LVR is 75%. That means you’d need to pay at least $25,000, and your lender would contribute the leftover $75,000. If the value of the shares falls by 10%, your investment is now worth $90,000, which means the LVR is now at 83.3%. To bring it back down to 75%, your lender may ask you to either sell some shares, or contribute cash or securities.
Red flags: watch out for these loan scams
There are a lot of loan scams out there, but luckily, they’re pretty easy to spot. Here are some signs to watch out for.
- No credit check
While there are some legitimate loans that don’t require a credit check, you should be wary any time it seems just a little too easy to get a loan—as you’ll usually end up paying for it later. Literally. For instance, payday loans, which don’t require a credit check, tend to charge whopping fees and sky-high interest rates.
- Rushing through the agreement
A lender who tries to rush you through the loan process—without letting you read the paperwork before signing it, for instance—is probably trying to hide something. If you feel rushed or if you’re told to ignore the fine print, that probably means there’s something in there that the lender doesn’t want you to see.
- Too good to be true
If the terms of a loan seem too good to be true, they probably are. This includes unreasonable promises (usually made by con artists trying to trick you into a terrible agreement) and uncommonly low interest rates (that usually shoot up after an initial period).
Other warning signs include:
- Discrepancies between what you’re told and what the paperwork says
- A lender telling you to falsify the information in your application
- A lender who seems to be dodging your questions
