The 5 Different Types of Debt

You’ve probably heard the terms ‘secured debt’ and ‘unsecured debt’ or ‘revolving’ and ‘nonrevolving’ debt. And while these terminologies are a great mechanism in categorising the different ways debt can operate, it’s a narrow view and, quite frankly, confusing if you’re unfamiliar with how it all works.

The reality is debt has a purpose, which is why at PCR, we like to look at it from the perspective of what areas of your life debt may be beneficial or harmful. To clarify things, we’ve broken it up into 5 different types of debt.

Personal Debt

Personal debt includes things like credit cards, personal loans and car loans. This is the bad stuff- the devil of all debt, so to speak. Credit cards can be a helpful tool and a good way to get those rewards points, but you should prioritise paying them off monthly to avoid interest charges or late fees, which can stack up quickly. Credit cards aren’t worth it if you don’t have the discipline to do that. As for personal loans, these are unequivocally the worst. Compound interest on personal loans always works against you, so avoid it at all costs.

Home Debt

This is the debt incurred for the purchase of your home – your mortgage. As long as the decision is well-considered, there isn’t anything particularly wrong with this type of debt. The problem with this type of debt is that people redraw against it for the wrong reasons – for that new boat or car – instead of using it as a source of cashflow to build investment nest eggs. Be careful with this type of debt; the banks are happy to keep lending to you forever on this type of asset. Also, since the debt is for your personal home, it isn’t likely to be tax deductible, so you will want to pay the debt down as quickly as possible.

Secured Debt  

Secured debt is incurred for the purchase of cars, equipment and other items. The purpose of the item and how it is purchased determines whether it is good debt or bad debt. If you’re running a business that needs equipment, the debt makes sense as it will provide lower interest rates than unsecured debt. If you use secured debt to buy a personal car instead of via tax-effective means, this is not the best use of debt, and on top of that, you are most likely paying higher rates of non-deductible interest (as per personal debt).

Business Debt

It doesn’t matter what you do in business – business debt is a guarantee. As soon as you start collecting money, you start owing money to someone. There is nothing wrong with business debt as long as it is used for its purpose. An overdraft should only be used to deal with cashflow timing issues and gaps between when you have to make payments and when you receive payments. Equipment finance should be used to purchase equipment that is actually needed for the business. However, there are two debts that you don’t want to accrue when you are in business: superannuation debt for employees and debt owing to the tax office. As soon as you start accruing those, it becomes very difficult to borrow money. This is where it’s critical to have an expert small business accountant to ensure you meet your compliance and tax regulations.

Investment Debt

If you want to generate wealth and improve cashflow, this is the best type of debt you can have, as it helps you purchase investments. Using this debt in the right way will give you enhanced returns over the long term and help increase your cashflow. It is important, though, to understand the difference between a debt repayment and an interest repayment. Too often, people come to us and think they can claim their full loan repayment on an investment property as a tax deduction when they can only claim the interest component.

If you’re looking for debt advice or assistance, speak to the debt advisors at PCR Accounting & Advisory on 03 9847 7516.