Can You Reduce Debt by Looking at it Differently?

Contrary to popular belief, not all debts are created equal.

At first, this might seem an academic issue, with no tangible impact in real life. 

But treating all debts in the same way can increase your stress and dilute your focus and resources as you’re trying to pay them off.

At Life Sherpa, we categorise debts as red, amber and green.

Red Debts

Red symbolises danger, so this category includes debts arising from spending more than you earn. They usually take the form of high-interest credit cards or personal loans. 

Red debts are the toughest to get rid of, but doing so gives you the greatest benefit. 

To stop these debts from getting bigger, you need to reduce your spending or increase your income. Then you can use the freed up cash to reduce and eventually close the outstanding balance.

Amber Debts

Amber symbolises caution, so amber debts are less of a concern. They arise from spreading the cost of long-lasting purchases (such as your home or car) over the period for which you owe the money.

These are usually lower-interest-rate loans and are backed by the same assets you purchased with the money you borrowed.

If your home costs no more than five to six years’ pay, your car less than three months’ pay, and the interest rate on the loan is competitive, you shouldn't worry about amber debts.

Your cash may be more productive elsewhere.

Green Debts

Green symbolises growth. Green debts relate to growing your asset base or earning capacity — think HECS, an investment property loan or a loan to buy shares.

As the highway code suggests, green means go, but make sure the way it’s clear before you hit the accelerator.

This means that, as long as the return on the asset funded with the loan exceeds the cost of debt, there is no benefit in paying green debts down.

For example, you can apply for a 3% loan to invest in a share portfolio that gives you a 4.8% return. Just make sure you’ve paid your red and amber debts first as it puts you in a stronger position (you’ll sleep better for sure).

And don’t worry about your HECS — it's not really a loan in the true sense of the word.

Why does HECS Need to be Treated Differently? 

HECS is just an income tax surcharge on graduates. 

The government treats it as a loan so the figures in the federal budget are perceived more favourably. But it’s just accounting smoke and mirrors and it doesn't change its actual cost.

My advice is to think about it as a graduate tax: it’ll feel less painful. 

Here are a few reasons why HECS is different:

• Your HECS balance doesn’t count as a loan when you go to borrow money. Banks only consider the impact of the HECS payment on your net income, not the balance on your HECS account.

• The amount you have to pay each year is based on your income (if it is above the threshold), not on the outstanding balance. If you don’t earn enough, you don’t have to make payments.

• Unlike many other debts, it also survives bankruptcy. When someone is declared bankrupt, all of their assets are taken to pay the debts and the balance is wiped clean. However, certain liabilities survive this process and HECS is one of them.

• There is no real interest charged, although your balance is adjusted each year to account for inflation. However, with interest rates at historic lows and inflation on the rise, this distinction may become irrelevant. In 2021, the indexation was 0.6%, down from 2.9% in 2012. Currently, home loan rates are as low as 2.19%.

For these reasons, paying student contributions up front to avoid HECS rarely makes financial sense. Similarly, there are very few circumstances in which making additional HECS repayments is beneficial. 

So, take advantage of the cheap money and easy terms from the government: it doesn’t happen often in your financial life!

Bottom Line

Now you see why not all debts are created equal and why you should treat them differently.

Start with your red debts, reducing them or stopping them from increasing. Then take care of the amber ones, which we’ve seen require less effort and resources if you follow Life Sherpa’s guidelines. Finally, you’re left with your green debts, which you can live with comfortably as long as they grow your assets or earnings.

In conclusion, the answer to our original question is yes. A simple and practical categorisation can help you reframe the way you look at your debts, so you can focus your efforts and manage them better!