Debt can be used to finance purchases that might otherwise be difficult to afford upfront. Many Australians use different types of borrowing such as home loans, credit cards, personal loans or car loans to manage larger expenses.
However, understanding how to manage debt effectively and reduce borrowing costs is important for long-term financial health. It can also be helpful to understand the difference between good debt and bad debt, and how different types of borrowing may affect your financial situation.
Below are several commonly discussed debt management strategies in Australia that people use to organise, reduce or better manage their debts.
Make repayments more frequently
Interest on many personal debts, including home loans and credit cards, is typically calculated on a daily basis. Because of this, making repayments more frequently may reduce the total interest paid over time.
Some common approaches include…
Changing repayment frequency from monthly to fortnightly
Dividing the monthly repayment in half and paying it every two weeks
Using tax refunds or additional income to reduce the loan balance
Making extra repayments when possible to reduce the principal sooner
For example, paying half of a monthly repayment every fortnight results in 26 fortnightly payments each year, which is equivalent to making 13 monthly repayments instead of 12.
Before increasing repayment frequency or making additional repayments, it may be important to check whether the loan has early repayment or extra repayment fees that could reduce the benefit.
Consider consolidating debt to reduce interest costs
Many households have multiple debts, such as credit cards, personal loans and car loans, each with different interest rates.
Debt consolidation involves combining several debts into a single loan, ideally at a lower overall interest rate. This approach can sometimes reduce total borrowing costs and simplify repayments by combining multiple debts into one account.
Potential benefits of debt consolidation may include:
A lower overall interest rate
A single repayment instead of multiple loan payments
A clearer overview of total debt obligations
For example, consolidating higher-interest debts such as credit cards or personal loans into a loan with a lower interest rate may reduce interest costs over time.
However, debt consolidation does not reduce the total debt on its own. If new debt continues to accumulate after consolidation, the overall balance may increase rather than decrease.
Some people choose to maintain their previous repayment level even after consolidating debt to help reduce the principal more quickly.
Borrowing to invest (gearing)
Another form of borrowing sometimes discussed in financial planning is borrowing to invest, also known as gearing.
Gearing involves borrowing money to invest in assets such as shares or property, allowing an investor to access a larger investment than they could with their own funds alone.
This strategy is sometimes referred to as good debt because:
The borrowed funds may be used to purchase assets that can grow in value
Certain borrowing costs may be tax deductible in some circumstances
However, gearing carries significant risks. Borrowing to invest can increase potential investment gains, but it can also magnify losses if the value of the investment falls.
Because of this, gearing strategies are often considered higher risk and should be approached with a clear understanding of the potential outcomes.
Possible outcomes when investing with borrowed money
When investing in assets such as shares or property using borrowed funds, there are generally three possible outcomes.
Positive gearing
Positive gearing occurs when the income generated from the investment is greater than the interest and other expenses associated with the loan.
This means the investment produces additional income after costs. That income may be taxable depending on individual circumstances.
Negative gearing
Negative gearing occurs when the costs of owning the investment exceed the income generated by the asset.
In some circumstances, certain expenses associated with the investment may be tax deductible. However, negative gearing still involves operating at a financial loss before tax considerations.
Because of this, many investors review both the potential risks and costs before using this strategy.
Neutral gearing
Neutral gearing occurs when the income from the investment is approximately equal to the cost of borrowing and other expenses.
In this situation, the investment neither produces additional income nor creates an ongoing loss from a cash flow perspective.
Understanding positive vs negative gearing
Some investors focus heavily on the tax implications of negative gearing. However, it is also important to consider the underlying financial position of the investment.
An investment that relies heavily on tax benefits while producing ongoing losses may still reduce overall financial outcomes if the asset does not increase in value.
For this reason, many people review both potential investment returns and borrowing costs before considering gearing strategies.
Additional information about borrowing to invest is available from ASIC MoneySmart, which provides educational resources explaining how gearing works and the risks involved.
Understanding debt management options
Learning about debt management strategies in Australia, including repayment strategies, debt consolidation and borrowing structures, can help people better understand the financial decisions involved in managing loans.
Educational resources such as ASIC MoneySmart and other financial information services can provide further guidance about budgeting, borrowing and managing debt.