Many people have debt. Not as many people realise that, if you have debt of any kind, then every dollar you spend is another dollar you have borrowed. That’s how debt works.

Huh?

Let us explain with an example. Let’s say you have an outstanding home loan of $300,000 and you are paying 6% interest each year. You get a bonus from work of $2,000 (post tax). If you spend that bonus on a nice holiday, then you have borrowed to pay for the holiday.

This is because if you could have used the $2,000 to reduce your debt from $300,000 to $298,000. By choosing the holiday instead, your debt has ‘gone up’ from $298,000 to $300,000. Having a holiday means you have more debt – which is why we say you borrowed the money for the holiday, even though you think you used your bonus to pay for it.

This means, of course, that you are also now paying interest on the money that you spent for the holiday.

Now, this does not mean that people with debt should never spend money on anything other than paying off that debt. You need to live! But it is worth remembering if you have debt. Do you want that debt to hang around?

Last week we wrote about good debt and bad debt. Good debt is debt that makes your life better. It is usually cheaper than bad debt (in terms of after-tax interest) and/or it provides a lifestyle benefit such as a house for your to live in.

If your debt is good debt, then there is sometimes no rush to pay it off. In fact, it can make sense to not repay that debt unless you really have nothing else to do with your money.

Again, let’s think about an example. Let’s say that the $300,000 loan above is actually for an investment property. Your tax rate is 34.5% (icl Med Levy), meaning that you get a tax deduction equal to 34.5% of the 6% interest you are paying. This makes the after-tax interest rate just a tick under 4%.

This is a relatively low interest rate. With the rate this low, you might decide that you really would like to take a holiday. And, so, you do. Yes, you have borrowed for the holiday. But at a relatively low rate.

(This is, by the way, why one of the best ways to manage debt is to pay off non-deductible debt first. If there are two debts with the same interest rate – such as an owner-occupier loan and an investment loan – the loan being used for a private purpose is actually more expensive. It makes obvious sense to pay off the most expensive debt first. Once your debt is being ‘cheapened’ by being tax deductible, paying it off is not as urgent).

Another reason you might choose not to actually pay off debt is if your debt is for a relatively small amount compared to your income or your assets. Again, let’s use the $300,000 amount from above as an example. If a $300,000 debt comes from a recent loan that you used to buy a unit worth $400,000, then paying down that debt ASAP makes sense. This will create equity for you and give you a buffer if the market falls. On the other hand, if the $300,000 is the amount remaining on an ‘old loan’ that you used to buy a house that is now worth $2 million, there is not such a rush to repay the debt. Even if the market falls (as it has been lately), you are not likely to run into any equity problems with a loan that is so small relative to the asset against which it is secured.

It might be time to relax and take that holiday!

Next week, we will take one last look (for now) at an aspect of debt that is often overlooked: debt is always repaid using after-tax money.