Not all debt is created equal
Many people wait until their home loan is repaid before starting to invest. Unfortunately, this means they invest later in life, limiting the growth potential of their investments. There is, however, a strategy that lets you invest now and continue to pay off your home loan reasonably quickly. It’s called ‘debt recycling’.
The aim of debt recycling is to increase a person’s wealth more quickly by reducing debt that is not tax deductible and increasing debt that is tax deductible.
Good vs bad debt
Having debt isn’t necessarily a bad thing. Essentially, there are two types of debt: ‘good’ and ‘bad’ debt.
If the debt enables you to purchase assets that increase in economic value and achieve a tax deduction for borrowing costs, so that you grow your net wealth, it can be considered ‘good’ debt.
Debt arising from borrowing for items that depreciate or lose economic value over time (cars, plasma TVs) is definitely ‘bad’ debt.
How it works
Debt recycling involves three key steps:
- Use your home equity as security for a separate investment loan and invest in a diversified portfolio of quality investments.
- Use the investment income and any tax savings you receive from your investments (as well as any surplus cash flow) to help reduce your outstanding home loan balance.
- At the end of each year, re-borrow from your investment loan the amount you have paid off your home loan, and purchase additional investments.
Getting started with debt recycling
Before embarking on a debt recycling strategy, the first step is to ensure your cash flow is in order. This is vital, as you need to comfortably manage your existing financial commitments before attempting to carry additional borrowings.
Tips and traps involved with debt recycling
This is certainly an attractive strategy at first glance, but it isn’t for everyone. Below are some key points to consider:
- Investing successfully using debt recycling means investing for the long term, say, for at least five to seven years.
- Debt recycling may mean it takes a little longer to eliminate your home loan than it would otherwise.
- Consider a split loan structure, with an interest-only loan on the investment loan component so you can direct more surplus cash flow into paying off your home loan. Once the home loan has been repaid, the priority should be to reduce the investment loan over time.
- You need to be disciplined with your spending to reap the maximum benefit from a debt recycling strategy. If you simply spend your investment income rather than using it to reduce your loan balances, you will simply have more debt to pay off over a longer period, which isn’t the best outcome.
Recycling your debt is just one of many strategies designed to build your wealth and reduce your bad debt. Please contact us if you would like to discuss this strategy.