Debt Recycling – how to generate wealth from debts
As kids, we’ve all been taught that the good life is one where you get a good education, get a decent job, build a career, buy a home, pay off your debt, and then retire. The problem with that view is that you’re spending your best days using most of your income to pay off a mortgage.
So, when do you start investing for your golden years?
Allow us to introduce the concept of debt recycling.
Debt recycling allows you to change the average scenario described above into one where you make your debts do the work for you. It is a strategy whereby you can change your non-deductible debt (such as your home loan) into tax-effective, income-generating investment debt.
Before we explain what it is, let’s define the three types of debt:
1. Bad debts
These are debts that you have against depreciating assets, such as credit cards or other consumer debt. They aren’t beneficial to your financial situation.
2. Necessary debt
This is non-tax-deductible debt that is hard to avoid, such as your home loan.
3. Good debt
This is tax-deductible debt taken against income-producing assets, such as an investment or business loan. This type of debt can help you build wealth.
How does debt recycling work?
In essence, debt recycling allows a homeowner to use the equity built in a home to purchase investment assets. These could be property, shares, or any other asset aimed at generating long-term wealth. Using debt recycling allows you to convert necessary debt into good debt.
This strategy is not for beginner investors or people with a low appetite for risk, as such, we recommend that you talk to one of our financial advisers or an assessment before you make any decisions.
Accordingly, in order to be able to recycle your debt, you need to have paid-off enough of your home loan to be able to withdraw this money and repurpose it into another loan.
In plain English:
Every property has a certain value. This value changes over time according to market prices. When you first purchase a home, you take out a mortgage based on the valuation of the property. Given enough time, you repay a chunk of the loan. The amount you have repaid off the principal loan minus the current value of your home (which may appreciate or depreciate, depending on the market) is the equity it currently holds.
Most loan providers allow you to withdraw up to 80% of the equity you have built. So, assuming you have a $300,000 loan and have built a $100,000 in equity, you may take out $80,000 of this equity and repurpose it into an investment loan. You then use this new loan to purchase investment assets.
All the income generated by these assets is then repurposed into repaying the initial home loan (the non-deductible debt), which has reverted to its initial value since you’ve used up the equity.
|What nobody tells you is that you now have two debts to repay: the initial home loan as well as the new investment loan. This means that you need to have a stable income that can be used to pay off the new loan so that your investment income can repay the home loan.
One of the main benefits to debt recycling is that the investment loan’s interest is completely tax deductible. However, this is IF AND ONLY IF the generated investment funds in addition to your main income are less than your total marginal tax rate– as in, you are negatively geared. This means that the higher your marginal tax rate, the more tax effective is this strategy.
There are many ways that you can implement debt recycling, depending on your situation and the amount of flexibility you are looking for in the new loan as well as your time-line. For example, if you are planning to retire sometime in the next 5-7 years, this strategy is not for you. Additionally, debt recycling depends on the type of loan you want to take out, your loan provider, and market fluctuations.
As such, there are a lot of variables to consider before you commit to recycling your debt. Contact our financial experts as they can help you tweak this strategy to best fit your situation as well as work with our mortgage broker partners to get you the best possible offers on the market.
Disclaimer: Information included in this post is of general nature, it has been prepared without taking into account your specific situation. It is not intended to be and does not constitute financial advice, investment advice, trading advice, or any other advice. You should not make any decision, financial or otherwise, based on any of the information presented here without undertaking independent due diligence and consultation with a professional accountant or financial adviser.