Australia is third in the world for household debt but should we be concerned?
After all, not all debt is “bad” debt.
But if you’re in debt like most Aussies, how do you know that it’s at a “safe” level? What is a good debt ratio to be running at?
The following will help you work that out.
Balancing debt levels with short-term and long-term needs
How much debt you hold will depend on your financial strategy and your risk tolerance.
Households running a high debt level could get themselves into trouble, particularly if there is a strong interest rate rise.
Therefore, the question is: how much debt should you hold to avoid a financial catastrophe?
If you don’t have any cash reserves or insurance and your budget is tight because of the interest you’re paying on your debt, then you may already be one interest rate rise away from trouble.
Your level of debt needs to be balanced with your current cash flow requirements and your long-term goals.
You may need to make adjustments to your insurance to make sure that you’re protected if you suffer serious illness or injury that prevents you from earning income.
Of course, the last thing you want is to have to sell your home because you can’t afford the repayments.
It helps to calculate your debt to asset ratio. Let’s look at an example…
What is a good debt ratio when home-buying?
A couple is considering whether to upgrade their current home valued at $800,000 and purchase their dream home, which is $1.5M.
Their only other assets are super of $200,000 combined.
Their current debt is $500,000. However, with the increase and, taking into account stamp duty and real estate fees, etc. their new home loan would be $1.25M.
This would increased their debt to asset ratio significantly from 50 percent to 73 percent.
This may still be fine, providing the right measures are in place, such as cash reserves and insurance.
An alternative to increasing the debt ratio
In the above scenario, a better strategy may be to increase super contributions to save tax and build assets before purchasing the dream home.
Purchasing at a later stage will mean more assets due to the tax savings and a lower debt ratio, which means lower risk.
A good debt ratio for other investments
What is a good debt ratio when considering your other investments, such as properties and share portfolios?
Long-term research suggests that a well-managed 50 percent debt to asset ratio is generally appropriate.
However, if your want to maximise tax deductions, you can run at higher levels of debt providing you have contingency plans in place if your assets suffer from market volatility.
More conservative investors would look at running a 30 percent gearing ratio. However, this means that the potential for growth is reduced.
Questions about debt ratio?
Speak to a financial advisor to work out what the best debt ratio is for your stage of life and your lifestyle, taking into account your assets and investments.
This is a complex area and working out what is suitable for you, based on your long-term goals and current financial position, requires the expertise of a professional.
Feel free to contact us here.
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