As the financial year draws to a close, business owners and individuals alike begin reviewing their financial standing to optimise tax benefits, improve cash flow, and plan for the future. One crucial aspect of this review is managing debt – specifically, deciding which debts to pay off and which ones to retain.
Not all debt is created equal. Some forms of borrowing can be a powerful tool for growth, while others can become a financial burden. Understanding the difference between good debt and bad debt will help you make strategic decisions as you wrap up the financial year.
Understanding Good Debt and Bad Debt
Debt, when managed wisely, can contribute to wealth creation and business expansion. However, certain types of debt can erode your financial stability if left unchecked. Let’s break it down:
What is Good Debt?
Good debt refers to borrowing that has the potential to increase your net worth, generate income, or appreciate in value over time. It is often associated with investments in business growth, property, or education. These debts typically come with lower interest rates and, in some cases, tax advantages.
Examples of Good Debt:
- Business Loans – If a business loan is used for expansion, purchasing essential equipment, or investing in revenue-generating activities, it can be considered good debt. These loans are often structured with favourable terms and may offer tax-deductible interest.
- Mortgage Debt (Investment or Business Properties) – A property loan for commercial use or rental investment can provide long-term financial benefits through capital appreciation and rental income. The interest on business or investment property loans may also be tax-deductible.
- Education Loans – Borrowing to upskill or gain qualifications that lead to higher income potential is an investment in your future. If the return on education translates into increased earning capacity, this debt is considered beneficial.
- Asset Financing – Loans used to purchase income-generating assets, such as commercial vehicles, business machinery, or technology systems, can improve operational efficiency and profitability.
What is Bad Debt?
Bad debt, on the other hand, is borrowing that does not generate income or appreciate in value. These types of debt often come with high interest rates and can create financial strain if not managed effectively.
Examples of Bad Debt:
- Credit Card Debt – Credit cards often carry high-interest rates, and if balances are not paid in full, they can accumulate rapidly. Since credit card spending is usually tied to consumption rather than investment, it is considered bad debt.
- Personal Loans for Lifestyle Expenses – Borrowing for discretionary expenses such as holidays, luxury items, or non-essential purchases can lead to financial stress, particularly when interest accumulates over time.
- Buy Now, Pay Later (BNPL) Schemes – While BNPL services can be convenient, they encourage impulsive spending and can quickly lead to unmanageable repayment schedules, impacting cash flow.
- Car Loans (for Personal Use) – While a car is often necessary, it is a depreciating asset. Taking on a high-interest car loan for a non-business vehicle is generally considered a financial liability rather than an investment.
What Debts Should You Prioritise Before the Financial Year Ends?
With the distinction between good and bad debt in mind, here’s a strategic approach to managing debt as you close out the financial year:
1. Pay Off High-Interest Bad Debt First
The first priority should be eliminating high-interest bad debts, such as credit card balances and personal loans. These debts do not contribute to wealth creation and can quickly spiral out of control if not addressed. Paying them off before the financial year ends can improve cash flow and reduce unnecessary interest costs.
2. Consider the Tax Implications of Debt Repayment
Not all debts need to be paid off immediately, especially if they have tax advantages. Interest on business loans, investment property mortgages, and certain types of asset financing may be tax-deductible. Before making large repayments, consider whether retaining these debts could provide tax benefits in the current or next financial year.
3. Review Loan Terms and Refinancing Options
Some loans have early repayment penalties, while others may be eligible for refinancing at a lower interest rate. If you have existing loans with unfavourable terms, now is the time to explore refinancing or debt consolidation options to reduce overall repayment costs.
4. Reduce Debt to Strengthen Your Credit Profile
A strong credit profile is essential for securing future financing on favourable terms. Reducing outstanding debt before the financial year ends can improve your creditworthiness, making it easier to access funding for business growth or investment opportunities.
5. Optimise Your Business Cash Flow
For business owners, reducing non-essential debt can free up cash flow for operational needs and future investments. If your business has surplus cash, consider whether paying down debt is a more effective use of funds than holding onto cash reserves.
As the financial year-end approaches, taking a strategic approach to debt management can help you improve financial health, maximise tax benefits, and set yourself up for long-term success. By focusing on eliminating high-interest bad debt while leveraging the benefits of good debt, you can make informed financial decisions that support your personal and business growth.
The content in this blog is intended to provide general insights and should not be regarded as professional advice. Each business situation is unique, and we recommend consulting with a professional for specific guidance. At Black Arrow Business Studio, we specialise in accounting and consulting services designed to support your business’s growth and success. Feel free to contact us for expert advice and customised solutions.
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