A common misconception that many people have is: all debt is bad debt. This isn’t necessarily true, especially when it comes to debt recycling.
Debt recycling is often seen as a strategy that only advanced property investors employ. But in reality, a debt recycling strategy is beneficial for any property owner interested in growing their wealth and subsequently reaching financial freedom.
If creating wealth from your income-producing assets sounds appealing, then we’ve compiled this guide just for you to find out everything there is to know about debt recycling.
How come all debt isn’t bad?
Debt definitely does exist, but it isn’t always as bad as you might think.
There are actually three types of debt that exist:
- bad debt,
- necessary debt, and
- good debt.
Bad debt: this is usually any kind of consumer debt for assets that’s value doesn’t appreciate, like car loans, personal loans and credit cards.
Necessary debt: this is non-deductible debt tied to a home loan, for example, an owner-occupied property.
Good debt: this type of debt is what we should be aiming for to build cash flow and wealth. This debt is tied to tax-deductible assets that produce an income and appreciate over time.
How to use necessary debt from your home loan to make good debt
This debt recycling strategy uses necessary debt, such as the equity in your home, to buy an asset that can create good debt and long-term wealth, like an investment property.
So, when you’re debt recycling, you’re paying off any non-deductible debt and simultaneously growing wealth. Remember, investment loans mean tax-deductible debt. For more insights on managing your loans effectively, you can explore this guide on How to Reduce Interest Rates and Save Money.
How does a debt recycling strategy work?
A debt recycling strategy means buying income-producing assets by using debt over and over again.
This starts by buying a property using a home loan. Once you’ve paid a large amount of that home loan off (without any default payments), you can apply to access the equity in your home. This can be done by refinancing your loan.
Here’s an example of debt recycling:
Charlie bought his first property using a $400,000 home loan which he’s been servicing diligently.
He could choose to refinance at the halfway mark when he’s paid off half the home loan. By then, his equity would be $200,000 (as long as the property value hasn’t increased or decreased during this time).
Charlie could draw and recycle half the equity ($100,000) as a deposit for a new investment property rather than saving up his own money. Doing it this way makes his entire property purchase 100% tax-deductible.
Anyone in the same position as Charlie will eventually reach the position to do the same thing.
How do I start debt recycling?
Try and pay off the home loan on the home you’re living in as soon as possible. That way, you can use the money you would have used to pay your mortgage, and put it towards extra repayments on the loan of your investment property. It will also reach completion sooner.
The aim of this cycle is to reach a point where you only have the investment loan repayments, meaning your tax-deductible debt is maximised so you can reduce your taxable income.
How do I know if debt recycling is the right strategy for me?
A debt recycling strategy won’t be optimal for everyone, so consider these things first if you want to use the strategy to produce an income:
- Do you have a consistent income, like a day job, separate from investment profits?
- Do you have a cash flow buffer in case you need on hand, such as an offset account on a home loan?
- Can you afford to get income protection insurance?
The right mindset is just as important as having the means when it comes to debt recycling:
- Will you be able to see the longevity of the investment without being impatient?
- Are you prepared to increase your debt?
- Can you deal with risks or short-term fluctuations that could occur?
Lastly, there are several risks to consider that could hinder a debt recycling strategy from being successful:
- the risk of investments performing badly so a home loan ends up with no returns,
- defaulting on payments can make things go downhill very quickly and it’s a slippery slope to get on top of things again, and
- the cash can increase, meaning your home loan interest rates will too, so you’ll have to have a buffer to be able to continue covering the higher interest payments.
How a Professional Can Help
Debt recycling is a complex strategy, so beginners are advised to seek assistance and guidance from a financial advisor or accountant.
A mortgage broker can:
- advise on the best home loan products suitable to your circumstances and goals,
- help prepare your home loan application,
- assist with home loan refinancing and accessing your home equity,
- provide guidance on using your home equity as a deposit for another property,
- help you grow your investment portfolio.
Key Takeaways
Debt recycling is a complex but rewarding strategy consisting of a long-term process where assets that are still being paid off can produce an income.
A simple way to explain debt recycling is to look at debt as good, necessary and bad.
Necessary debt is something like a home loan, which is used for an investment – that is creating good debt.
This process includes paying off a great deal of your home loan before refinancing it and accessing the home’s equity. The equity is then recycled into an income-producing asset such as an investment property.
Keep in mind that debt recycling isn’t easy or for the faint hearted. To employ this strategy, it’s imperative to have a consistent income, as well as excess money acting as a security blanket. You also must maintain the right mindset for this strategy to be successful.
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