Debt recycling is a strategy that aims to help you pay off your non-deductible debt (eg your home loan) as quickly as possible, while also building your wealth in a tax-effective way over the longer term. It involves replacing or ‘recycling’ the debt in your family home with tax-deductible debt from investments. Now that interest rates have increased, this strategy works more effectively and is back on the radar of those wanting to build wealth and are comfortable with the risks involved. It’s not for everyone so you need to carefully consider the what-if’s.
How does the strategy work?
This strategy involves using equity from your home to invest in growth assets (typically shares). Over time, the earnings from these investments may be paid towards your home loan, helping to pay it off faster than if you were just making regular payments.
In most cases the interest on investment loans is tax deductible. Therefore, this strategy has the potential to create a tax saving, which can also be put towards your home loan. In addition, if your new investments go up in value, you’ll be building your wealth at the same time.
At the end of the first year, the goal is to increase your investment loan by the same amount that you have paid off your home loan and reinvest that increased amount. So you can see that over time the recycling of bad debt is replaced with good debts to repeat this process each year until your investment loan entirely replaces your home loan.
What are the risks?
Debt recycling is considered a high-risk strategy because you’re using borrowed money to invest and using your own home to secure that debt. If your investment performs poorly or interest rates increase, you could face significant financial stress or even put your family home at risk. Before diving into this strategy, it’s important to carefully consider these points:
Borrowing money to invest can lead to bigger gains when markets are rising. However, when markets are falling, your losses will be larger as you still have to pay interest and repay the loan.
We are living in a rising interest rate climate, a rise in interest rates can lead to your repayments increasing. This can put pressure on your cash flow, which can be compounded further if the income from your investments is lower than expected.
Investments bought with borrowed funds can fall in value. This means that even if you receive tax deductions from the investment over time, it can still fall in value, and you can still be in debt even when you sell the investments.
It takes discipline to use the investment income and tax savings for your home loan each year, instead of spending it on things like a holiday, or new car. This strategy is not for the spenders!
If you take on debt of any kind, you should review your insurance cover to ensure the extra loan can be repaid in the event something happens to you.
For a debt recycling strategy to work, you need to have a home loan with equity in your home. You will want to have a regular income with surplus cash flow – that way, in the event the investment income is low or interest rates rise you can still meet the loan repayments. You will need to be comfortable increasing your debt levels and you should have a long term time horizon (10 years+).
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General Advice Warning - This communication has been prepared on a general advice basis only. The information has not been prepared to take into account your specific objectives, needs and financial situation. The information may not be appropriate to your individual needs and you should seek advice from your financial or tax adviser before making any investment decisions.