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Debt Recycling

Debt Recycling Diagram

DEBT RECYCLING:

WHAT IS IT AND IS IT RIGHT FOR YOU?

Like you no doubt, we have all seen and heard different solutions to growing your wealth. This particularly applies to your social media platforms such as Facebook and LinkedIn. However, we hope that you won’t fall into the trap of committing yourself to such arrangements without knowing if that form of investment is right for you.

In fact, this is a good time to highlight to you that debt recycling is generally considered to be a high-risk strategy.

So, what is debt recycling?

Debt recycling is a strategy that you can use to pay off debt that is not tax-deductible, such as a home loan, while simultaneously growing your wealth. Often, this can involve a homeowner using equity in an existing home to purchase an investment asset. As such, your asset could be an investment property, shares, or another asset aimed at creating your long-term wealth.

How do you feel about using the equity in your home to invest? Specifically, investing in income-producing assets with the possibility of growth, is the basis of this strategy. Hence, one popular investment method for you to consider is to purchase dividend-paying shares or a property that can be rented out.

Consequently, over time, your investment should begin producing income which you can then use to pay off your home loan through extra repayments. As such, this will increase your home equity, allowing you to borrow more money for investing purposes. And so the cycle goes on.

In summary, debt recycling is a possible means of turning your non-deductible debt into tax-deductible debt. Therefore, it’s an early mortgage repayment strategy that is typically used by advanced investors.

How does the debt recycling strategy work?

For many of those who take on this strategy, it’s seen as a battle between “good” debt and “bad” debt. The difference is often reflected upon as to whether a debt has taxation benefits attached, or otherwise.

Typically, if you have investment loans, the interest is tax deductible. That means, this strategy has the potential to create a tax saving for you, which can also be put towards your home loan. Additionally, if your new investments go up in value, you’ll be building your asset wealth at the same time.

At the end of the first year, your goal should be to increase your investment loan by the same amount that you have paid off your home loan and reinvest that increased amount. As such, the idea is for you to repeat this process each year until your investment loan entirely replaces your home loan.

What benefits does debt recycling offer?
  1. Save on tax: this strategy helps turn non-deductible debt (i.e., home loan repayments on a family home) into debt that comes with tax benefits (i.e., the interest on an investment loan).
  2. Exposure to growth assets: debt recycling can give you access to assets you may not have been able to afford without following this strategy.
  3. Passive income: if all goes according to plan, you’ll end up generating a passive income through your investments.
What are the risks in debt recycling?
  1. Poor performing investments: if your investments don’t perform well, you’ll have an investment loan to deal with and no returns to help you out.
  2. Taking on more debt: having more loan repayments can become overwhelming if not managed well. Therefore, missing repayments or defaulting can put your home at risk, leaving you open to losing everything.
  3. Shifting costs: the cost of this strategy will rise if interest rates increase. Also, you must also consider any fees associated with getting a new loan.

Debt recycling is considered a high-risk strategy.

This is because you’re using borrowed money to invest and using your own home to secure that debt. Subsequently, if your investment performs poorly or interest rates increase, you could face significant financial stress or even put your family home at risk.

Before implementing this strategy, it’s important to carefully consider these points:

  • Borrowing money to invest can lead you to bigger gains when markets are rising. However, when markets are falling, your losses will be larger as you still must pay interest and at some point, repay the loan.
  • If the interest rate on your loan isn’t fixed, a rise in interest rates can lead to your repayments increasing. So, this can put pressure on your cash flow. Furthermore, this can be compounded further if the income from your investments is lower than anticipated.
  • Any assets bought by you with borrowed funds can fall in value. This means that, even if you receive tax deductions from the investment over time, it can still fall in value. Additionally, you can still be in debt even when you sell the asset.
  • It will take willpower and discipline on your part to use the investment income and tax savings for your home loan each year. Rather than spending it on a “want” such as a holiday or a new car, you’ll need to stick to your plan.
  • If you decide to pursue this strategy, it’s worth reviewing your insurance cover to ensure that the extra loan can be repaid in the event something happens to you.
Are you an investor with a low risk appetite?

If so, be aware that debt recycling can present a number of risks. Such a strategy is dependent on the performance of your investments and you could risk a high level of financial stress.

To minimise the risk, it’s important to consider your whole financial situation very carefully. Looking at your cash flow, expenses, existing debts and assets will help to ensure you will be able to make the most out of this strategy.

To summarise the above, it’s important to note that:

  1. You will need to be able to maintain a long-term investment focus
  2. You must have a willingness to increase your debt and hold an investment loan
  3. Having a tolerance for risk and short-term fluctuations in investment value is essential
  4. You should consider income protection insurance, which may provide replacement income if you’re sick or injured and unable to work.

Final Word

Debt recycling isn’t suitable for everyone. Hence, if you’re considering this strategy, it’s important to understand all the risks involved. Consult with your financial adviser as he/she may help you to determine if this strategy is right for you. To make a start on finding out more about this strategy with your financial adviser, please go to our contact page.