Debt recycling can be a powerful strategy designed to swiftly pay down non-deductible debt and transform it into tax-deductible debt, potentially propelling your wealth creation journey. Learn how this approach involves strategic investments, utilising income to expedite home loan repayments and ultimately replacing it entirely with the investment loan.
A close look at how it works
Debt recycling involves drawing equity from your home to invest in income-producing assets such as shares or investment property.
For example, you are paying your home loan when you have $500,000 that you have built up in equity. You can then draw out some of this equity and invest it into the property market or shares.
The interest that is applied on the new investment loan to purchase the investment property may be tax-deductible. In which case you may be able to use the tax savings and investment income to pay down your family home loan more quickly.
You have created multiple assets, one of which produces income that helps to pay for the costs of the other.
If your new investments go up in value, you will be building your wealth at the same time.
At the end of the first year, you could increase your investment loan by the same amount that you have paid off your home loan. Reinvest this increased amount systematically each year, aiming to eventually replace your home loan entirely with the investment loan.
All strategies that involve gearing (that is borrowing money) are inherently higher risk. Our Senior Financial Adviser Hung Nguyen believes with the right planning this can be an appropriate strategy in in the right circumstances. Hung believes it’s great to have strategies that can address multiple goals at once. Debt recycling enables you to pay more money off your home loan each year while consistently building an investment portfolio that may grow over time.
Navigating the risks: Five things to consider
It’s important to evaluate whether this strategy aligns with your financial goals and risk tolerance.
Debt recycling is a high-risk strategy as you are using borrowed money to invest, as well as using your own family home to secure the debt. Therefore, if the investment goes south or if the interest rate increase, you may suffer financial stress and in extreme circumstances can even put your family home at risk. You need to be comfortable and confident that you can keep paying your loans.
Our team have come up with five points to consider, before delving into this approach, as this is not a strategy that is ideal for everyone.
- During favourable market conditions, leveraging borrowed funds for investment can amplify profits. Conversely, in a declining market, the losses incurred are magnified due to the ongoing obligation of interest payments and loan repayment.
- If the interest rate on your loan is variable, a surge in interest rates may result in higher repayments. This could strain your cash flow, particularly if your investment income falls below expectations. A secure income is crucial for comfortably servicing both loans and maximising tax advantages. It is recommended for those with a stable income.
- Assets acquired through borrowed capital are susceptible to depreciation. Despite potential tax deductions over time, the value of the investment can still decline, leaving you with debt even upon selling the asset.
- Exercising restraint and financial discipline is crucial when redirecting investment income and tax savings towards your home loan. Resisting the temptation to spend these funds on non-essential items like vacations or new vehicles requires a dedicated commitment.
- Should you opt for this strategy, it is advisable to reassess your insurance coverage to ensure that any additional loan can be settled in the event of unforeseen circumstances, such as death or incapacity, affecting you.
When introducing this strategy to our clients, we meticulously assess every aspect of your financial situation. This ensures that debt recycling aligns effectively with your individual financial circumstances and that it will successfully accomplish your specific objectives.
Benefits of Debt Recycling: A path to financial prosperity
We have seen that when debt recycling has been actioned correctly, the benefits include:
- Owning your family home sooner
- Save on tax
- Diversifying and building wealth through your investments
The benefits from debt recycling can vary from client to client depending on your situation, income and financial goals
Is Debt Recycling right for you?
While debt recycling offers favourable outcomes such as using investment income for additional repayments and replacing non-deductible debt with tax-deductible debt, it’s important to approach the strategy with care. It is not a quick fix and requires perseverance, good savings, and money management skills. Successful implementation demands a commitment to paying off debts.
While experienced investors may feel confident in managing it independently, working with your adviser and our team is advisable for a thorough evaluation of one’s financial situation.
Are you considering debt recycling? Our experienced team of advisers can guide you through the process, providing tailored insights into your unique financial situation. Explore the potential benefits, weigh the risks, and make informed decisions to accelerate your journey toward financial prosperity.
Speak to your adviser today or contact our team here.
