If you’re still under the guise that all debt is bad debt, you need to know about debt recycling.
Most people see debt recycling as a strategy employed only by advanced property investors, but that simply isn’t the case.
A debt recycling strategy can be used by any property owner wanting to grow their wealth and reach financial freedom.
If you have debt and wealth creation using income-producing assets is of interest to you, then you to keep reading to find out more about debt recycling.
Why Isn’t All Debt Bad?
While debt does exist, it can indeed be bad – but not as bad as you think.
There are other types of debt too:
- necessary debt, and
- good debt.
Bad debt is typically any type of consumer debt against assets that don’t appreciate in value, like credit cards, personal loans and car loans.
Necessary debt is the non-deductible debt that comes with your home loan, such as your owner-occupied property.
Good debt is the type of debt we should aim for to build wealth and cash flow. This debt is for assets that are tax-deductible and produces income. These assets will appreciate with time.
Using Necessary Debt From Your Home Loan To Produce Good Debt
The debt recycling strategy entails using the equity in your home (necessary debt) to purchase an asset that will create long-term wealth (good debt) such as an investment property.
So, debt recycling means you’ll be paying off non-deductible debt while growing your wealth at the same time. And, an investment loan means tax-deductible debt.
How Does a Debt Recycling Strategy Work?
Debt recycling is a strategy to use debt over and over again by buying income-producing assets.
Debt recycling begins by using a property you’ve purchased via a home loan.
Once you’ve paid down a considerable amount of your home loan, with good serviceability and no default payments, the first step in debt recycling is to apply to access your home’s equity. You can achieve this through refinancing your home loan.
Let’s use Seth’s home loan as an example of debt recycling. Seth took out a home loan of $400,000 some time ago. He has been servicing his home loan diligently.
In Seth’s case, he might choose to refinance his loan when he has paid off half of his home loan. His equity would then be $200,000 as well (assuming his house value hasn’t fluctuated during this time).
Instead of using his own savings, he could instead draw out and recycle $100,000 of the equity and use it as a deposit for an investment property purchase, therefore making his total purchase of the property 100% tax-deductible.
If you are in a similar position to Seth, with time, you will reach the position where you can do the same thing with this new investment property.
Once you have paid off the home loan on your owner-occupied home, it’d be wise to use the money you were using to pay off your mortgage and make extra home loan repayments on your investment property so that it will reach completion sooner.
With this cycle, the aim is to reach a position where only the investment loan repayments remain, maximising tax-deductible debt in the hope to reduce your taxable income.
Is a Debt Recycling Strategy Right for You?
To have a successful income-producing debt recycling strategy, there are a few things to put into place first:
- it would be best for debt recycling if you had a consistent income that’s separate from the profits of your investments, such as a regular day job,
- you should have a cash flow buffer in case you need money on hand, and this cash flow can be in the form of an offset account tied to a home loan, and
- in the interest of long-term financial planning, it will be beneficial to take out income protection insurance.
Then you need to focus on having the right mindset for debt recycling:
- be able to focus on the longevity of the investment,
- be willing to increase your debt, and
- be tolerant towards risks and any short-term fluctuations that might occur.
While recycling debt can be a very successful investment strategy for many people, there are risks involved too:
- there’s always a chance of investments performing poorly and resulting in a home loan with no returns,
- if you default on any payments, it’s a slippery slope to climb back on top of things without getting a bad record or even having property repossessed, and
- if the cash rate goes up, so will all your home loan interest rates, so you’ll have to consider whether you can afford to cover the interest payments.
Debt recycling is a strategy of a long-term process that can result in income-producing assets – while they’re still being paid off.
An easy way to describe debt recycling is by using the sentiment of good, necessary and bad debt, where necessary debt (like a home loan) is used to purchase good debt (an investment).
This can be done by paying off a large amount of a home loan and then refinancing it to access the property’s equity. The equity in your home should be recycled into any income-producing asset.
But, debt recycling isn’t for the faint of heart. Besides having a consistent income and excess security blanket, you need to have the right mindset to be successful at debt recycling.
If you think you’re up to the challenge of debt recycling, our mortgage brokers would love to help you along your wealth creation journey. Contact us today to start growing your investment portfolio.
Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to property buyers and investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal, tax or investment advice. You should, where necessary, seek your own advice for any legal, tax or investment issues raised in your affairs.
Written/vetted by Jamie Kwok, JMKPartners. This article should be used as a guide only.