Everything you need to know about debt recycling
For decades now we’ve been told repeatedly about the importance of recycling. But how much do you know about the kind of recycling that leaves you better off financially? And no, we’re not talking about collecting a bunch of bottles and cans and exchanging them for 10 cents a pop.
We’re talking about debt recycling. More specifically, taking bad debt and recycling it so that it turns into good debt. Here’s what you need to know.
Telling the good from the bad
The obvious examples of bad debt are car loans, personal loans and credit card debts. These charge disproportionately high interest rates and are either attached to an asset that loses value at lightning speed (car) or something designed to put you into more and more debt by buying things before you can afford them (credit card).
Good debt on the other hand is anything that is tax deductible and also a vehicle for growing your wealth. Investment properties are the obvious example as you can deduct interest paid on the loan, and the property grows in value over time, while producing a solid income.
Not all forms of bad debt can be recycled into good debt. Today we will focus on the mortgage you may have on the family home. A lot of people will tell you this is actually good debt… and compared to credit cards, it is. Interest rates are low and the home will grow in value over the years, hopefully helping to set you up for a comfortable retirement.
But a savvier investor would class it as bad debt because the interest is not tax deductible and it may not work as hard as other assets to grow your wealth. Recycling your mortgage debt is a strategy to minimise your tax obligations and maximise tax benefits. So how do you turn the bad into the good?
Let’s get recycling
Debt recycling involves using the equity in your family home to purchase an income-producing investment asset. You use the income that the new asset produces to pay down the debt on your family home mortgage, while leaving the tax deductible investment loan as is.
At that basic level, you’ve taken an asset with interest repayments that aren’t tax deductible and replaced that with two assets, while making the same repayments on your home and being able to deduct the interest payments on the investment property.
Why do it?
Back in the day, Aussies would slog it out to pay down the family home first, before then thinking about using their income to the start purchasing investment properties. But by waiting all that time, you have missed out on buying investments when they are cheaper and then holding them through multiple growth cycles. The earlier you start building your investment portfolio, the greater the benefit from compound interest. The two assets mean you experience capital growth on both and therefore double your return when times are good and the market is on the way up.
So what’s the catch?
Twice the gain in good times, also means twice the pain if the market has a correction phase.
This will hurt if you have a short term investment strategy and can’t wait for the market to recover and grow again. Ideally you will be leveraging equity and using time in the market to maximise the benefits. The long game is best for debt recycling.
The other major issue is that you are placing risk on your family home, which most people rely on for their livelihood and sense of security. Jeopardising that could wreak havoc on relationships, family life and your mental health if you haven’t thought it through correctly.
You need a well-informed strategy in place, plus a decent income and job security, so you can service both loans and protect your home and family.
This article may give you an overview of the concept of debt recycling, but no two individuals are the same. Before going all in with the family home, seek independent financial advice and surround yourself with the right professionals to help make your journey a smooth one. And if you need help getting started, reach out to Binvested. We can help point you in the right direction.