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Do you really understand what productive debt is?

Do you know the difference between productive and unproductive debt?

In my experience, too many people have too much unproductive debt, and not enough debt that actually works for them productively to increase their wealth over time.

The debt equation calculator coin money save debt

I had a conversation with someone recently who was considering paying off their home loan because they had excess funds every month.

Now, this person is also an investor, but believed it would be better to pay down their home loan before purchasing another investment property as they were reasonably happy with their portfolio for the time being.

While everyone’s circumstances and goals are different, it didn’t take me long to recognise that there was a better way for our client to use those extra monthly funds.

The thing is if they started paying off their home loan, they would be using after-tax dollars to do so – so they’d already lost about 37 cents in every dollar.

Their plan was to pay it off in 10 years but generally speaking they could achieve the same goal without scrimping and saving every cent of their income to pay off the debt.

You see, a loan on your home is both after tax and unproductive debt because it’s not tax-deductible in any way, whereas an investment loan is the complete opposite.

An investment loan is tax-deductible and essentially you’re also using both pre tax and other people’s money – that is the bank’s – to create wealth, so therefore it is also productive debt.

A more productive way

So, in this scenario, I believe it would be better for that investor to buy another investment-grade property in a capital city rather than pay off their home loan to achieve their twin objectives. 

They can certainly afford to hold that additional property for the long-term because they currently have excess cash flow every month anyway.

By buying another investment property, and continuing to pay interest-only on their home loan, they will be reducing the repayments on their unproductive debt and increasing the taxation benefits of the productive debt on their new investment.

By the age of 55, so in 11 years’ time, this investor should have achieved enough capital growth in that new investment property to help to significantly pay down their home loan – if they at that time decide it is better to sell the investment grade property, all without using a cent out of their own back pocket.

In the meantime, if they continue to have excess cash flow every month, they could consider buying another investment property.

This example is why all investors need to better understand the difference between productive and unproductive debt so they can ensure they’re making the most of the former rather than the latter.

That way, they can work steadily towards financial freedom, without ever having to access their after-tax savings to do so.

Disclaimer

This article is general information only and is intended as educational material. Metropole Wealth Advisory nor its associated or related entitles, directors, officers or employees intend this material to be advice either actual or implied. You should not act on any of the above without first seeking specific advice taking into account your circumstances and objectives. 



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Ken Raiss

About

Ken is director of  Metropole Wealth Advisory and gives independent expert advice for high net worth individuals and their families, professionals and business owners. He is passionate about property investing and small business and shares his wealth of experience in his blogs. View his articles  


'Do you really understand what productive debt is?' have 4 comments

  1. March 24, 2017 @ 8:59 pm Tess Bell

    Hi there
    how much would the capital growth need to be to outweigh the interest you would have paid on be home loan for the ten years?
    Thanks

    Reply

    • Michael Yardney

      March 24, 2017 @ 9:12 pm Michael Yardney

      There is no simple answer because it depends on your loan to value ratio – the smaller your proportion of debt, the lower the capital growth must be. It also depends if it’s an income producing investment or your home

      Reply

  2. March 26, 2017 @ 6:55 pm rhorgan

    I think a productive debt, is and investment that pays a significant return.

    Reply

  3. March 26, 2017 @ 11:25 pm Marg

    I agree totally with this concept as it happened to me. Bought 3 IPs 17 years ago, paid interest only, after 10 years received the title of one property. Example (very general and high level overview), bought in QLD for $250K each 3 IPs say with $200K being 80% LVR. Fast forward 10 years, assume IPs grew to $400K each so by $150K each. Total value of 3 IPs is now $1.2 million, loans are still $600K so LVR lowered to 50% just because of time and growth, so now you can refinance and ask the bank to provide 2 IPs as security for the 3 loans (of $600K) or refinance and invest more! I though this was amazing that I never paid $1.00 off principal yet I was able to receive a title for one IP… People forget and don’t do research how much properties in major capital cities cost in the last 10, 20, 30 years ago! Also, remember the loans of $600K 10 years ago were worth much more (inflation), the purchasing power of $1.00 was more than 10 years on so really your $600K loan is really reduced if you think about it (food for thought).

    Reply


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