Most of us don’t think twice about recycling our plastics and paper waste to help save the environment, but what about recycling debt? Is that a good way to save money?
Debt recycling is the process of replacing mortgage debt, or bad debt, with investment debt, also known as good debt.
This strategy enables investors to start building wealth while they’re still paying off their home. As equity is built up in the home, funds are re-drawn and invested. Income from these investments can be used to further reduce the mortgage balance, while the growth component contributes to wealth accumulation.
Why can debt recycling be a good strategy?
The main benefit of a debt recycling plan is the ability to accumulate wealth tax-effectively. This is achieved as investors use the income earned on their good debt to pay off their home mortgage (bad debt).
But take note - the tax effectiveness of a debt recycling strategy is dependent upon the individual’s marginal tax rate. The higher the tax rate the more tax-effective the strategy; and vice versa. As such, tax advantages should not be the primary basis for using this approach.
Debt recycling also provides investors with an opportunity to fill the gap between their superannuation savings and retirement objectives. For many people super will be insufficient to fund their desired lifestyle. Additional wealth, accumulated as part of a sound debt recycling strategy, may be able to fill that void.
Are there any downsides?
Perhaps the biggest risk associated with this strategy is the threat of compounding losses. Whilst a geared investment strategy can help to build wealth faster, the opposite can also be true when markets experience a downturn. In a worst-case scenario, investors can end up owing more than the portfolio is worth. If you use the equity in your current home as security for the loan, you could be at risk of losing your home.
Investors should also be aware that the interest rates associated with loan facilities used in debt recycling strategies are often higher than the standard variable mortgage rate.
Debt recycling is not recommended for anyone with an investment timeframe of less than five years, and is only suited to those investors with a reasonable appetite for risk, and a secure income source.
How do you start?
To commence a debt recycling strategy, investors should first ensure they have the right loan structure. As some of the investment debt will have deductible interest costs, these amounts should be kept separate. A loan facility allowing separate sub-accounts is preferred, with the ability to choose between principal and interest. Interest only repayments are also desirable.
Debt recycling in action
Mark and Jane have built up considerable equity in their home, and upon advice from their financial planner decided to make that equity work harder for them. The couple currently owes $240,000 on their home, which is valued at $400,000. Their licensed planner recommends that Mark and Jane implement a debt recycling strategy, refinancing their current loan to give them a $300,000 loan limit. This releases $60,000 of available equity for investment.
Mark and Jane’s planner recommends they invest their $60,000 equity into a portfolio of managed investments specifically chosen for income potential. After one year, their portfolio has grown in value to $65,000, and yielded an income of $4,000 which is used to reduce their mortgage further. After regular loan repayments, their mortgage balance is $230,000 after the first year. The couple then draw the extra $10,000 in equity to make an additional contribution to their investment portfolio. This process is repeated each year until their mortgage is extinguished.
Debt recycling can benefit investors prepared to invest not just funds, but also time and patience. Want to know more? Contact us.
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Disclaimer and Warning
The information above is of a general nature only. It should not be used as a source to make financial decisions. It's also important to note that the legislation and figures related to this topic tend to change regularly and therefore the information above may not reflect the current status. We recommend that if you are looking for advice on this matter, you should contact us .