From a tax perspective, there are two main types of debt.
Non-deductible debt
Non-deductible debt arises where the interest on the loan is not tax deductible, for example, when a loan is used to buy a home to live in or you have a personal/car loan or credit card debt. These funds have been used to purchase an asset which will not produce an assessable income. The interest on this debt is not tax deductible and so has a higher after-tax cost than deductible debt and results in a direct drain on your after-tax cash flow.
Borrowing money for something that is not producing income, such as the family home or a new car is often referred to as ‘bad debt’.
Deductible debt
Deductible debt arises where the interest on the loan is tax deductible, for example, an investment loan. The reason an investment loan is tax deductible, is because the borrowed money has been used to invest in an asset that will generate assessable income.
If you are using the funds to buy something that produces an income (such as a share portfolio or investment property), the associated interest expense on the loan is tax-deductible. This would be an example of ‘good debt’ which can help your tax position at the end of the financial year.
In order of priority, it is generally more effective to pay off non-deductible debt first. This is because in paying for the non-deductible home loan, you are using after tax dollars to repay it, which means it has a higher after-tax cost versus deductible debt.
It is important to remember that deductible debt (good debt) is only ‘deductible’ while you have an income and are paying tax. If you are approaching retirement and are moving to a tax-free income from your superannuation or pension, the benefit of the tax deduction will be reduced.