Debt recycling isn’t a common term, and there are a lot of myths and misconceptions surrounding it. Put simply; debt recycling strategies are a way to pay your home loan debt off quicker whilst simultaneously accumulating a portfolio of income-generating assets.
Before we explain this concept, it’s important to note that this financial approach shouldn’t be made without the assistance of a trusted financial professional.
What is debt recycling?
Inovayt’s Managing Director, Nick Reilly, says, ‘Debt recycling is reducing your personal debt against your house and then using the equity in that house to recreate the debt and invest the money. As the name suggests, you’re recycling your debt from personal (non-tax-deductible) debt to investment (tax-deductible) debt.’
For example, a homeowner could essentially use the equity in their home to purchase an investment asset that is aimed at generating long-term wealth. When you recycle debt, the non-deductible mortgage gets smaller, while the investment loan generally gets bigger.
How does debt recycling work?
Before we break it down further, we wanted to reiterate the complexity of this strategy and advise you to enlist the help of a finance professional before undertaking any significant financial changes.
When it comes to debt recycling, typically, the interest on investment loans is tax deductible. This strategy can create a tax saving, which can be put toward your home loan, paying it off quicker than you may have otherwise been able to.
Debt recycling is a difficult strategy but can be extremely worthwhile if done correctly. The process may look like the following:
1. Access the equity in your home
Not every homeowner will be eligible for debt recycling. Firstly, homeowners must have built up some equity in their homes. The lower your loan-to-value ratio (LVR) is, the better. For those with an LVR above 80 per cent, it’s unlikely that you’ll be able to use your equity without being charged lenders mortgage insurance (LMI).
2. Borrow against your home
Once the equity in your home has been assessed, you can borrow this money against your property to start investing. If you’re looking to make the most of debt recycling, consider choosing income-producing assets, such as shares or an investment property that you can rent out. Your financial advisor will discuss which investment opportunity best suits your lifestyle.
3. Wait for the gains
Good things come to those who wait! Like anything worthwhile, you’ll need to wait to see your investment results. After a while, your investment will begin producing income which you can use to pay off your home loan through extra repayments. These additional payments mean that your home’s equity will increase, allowing you to borrow more money for investing purposes.
4. Embrace the cycle
This cycle of waiting for gains and borrowing more money for investment will become a financial cycle. As this continues, you’ll ideally end up with just the tax-deductible investment loan that you can focus on paying off. When done correctly, you’ll generate a passive income whilst paying off your debts.
What are the benefits of debt recycling?
Like other wealth-building strategies, debt recycling has a number of benefits which can differ depending on your financial situation, income and goals. Some of these benefits include:
Building your investment portfolio
Debt recycling can allow homeowners to build their investment portfolio when they otherwise may not have been able to. For experienced investors, it might also allow for the diversification of your portfolio. Diversification is a tool that investors can use to help mitigate risk and generate returns across a variety of assets. This means you’re not putting ‘all your eggs in one basket’.
Potential tax benefits
When done correctly, this strategy can help to turn non-deductible debt (e.g., home loan repayments on a family home) into debt that comes with tax benefits (e.g., the interest on an investment loan).
One of the main benefits of debt recycling is the potential to earn a passive income through your investments. This includes any money, such as rental returns from an investment property or dividends from stocks or EFTs. It’s important to note that passive income isn’t guaranteed, and there is always the chance you could lose money through investing.
Opportunity to pay off your home loan sooner
The assets that you purchase using the equity in your home have the potential to generate earnings, and if you do earn a profit from your investments, this profit can be put towards paying off the balance of your home loan. Paying off more of your mortgage means the equity in your property will potentially increase, allowing you to grow your investment portfolio.
What are the risks?
Benefits always come with an element of risk. Some of the potential downfalls of debt recycling include:
Potential for the investment income to fluctuate
Debt recycling on paper sounds like a sure-fire way to make money and pay off your home loan sooner, but an income isn’t guaranteed. If the market takes a downturn or your investments don’t perform as well as expected, you will still need to repay your investment loan. While borrowing money can lead to significant gains within rising markets, your losses will be more prominent as you still need to pay interest and service the loan. It’s crucial that you consider your financial position before opting for this strategy to ensure you’ll be able to manage these repayments and have a plan if something goes wrong and you can’t work.
Risk of interest rate rise
Variable interest rates are great for a number of reasons. When using a variable interest rate loan, homeowners can make additional repayments free of charge and may be able to access an offset account and redraw facility. However, it’s important to remember that if interest rates rise over time, your variable rate will increase, and you’ll pay more interest.
Debt recycling is a strategy used by homeowners to pay off their home loans sooner and build their wealth. It’s something that shouldn’t be attempted without the assistance of a financial advisor, as there are significant risks associated with it. If you’re looking to build your investment portfolio and pay off your home loan sooner, get in touch with one of our Inovayt professionals to discuss debt recycling strategies.