2 common questions I get asked is how do I pay of the debt on my family home faster and what’s the best way to build wealth and create passive income.
Most people have heard of debt recycling, but many don’t truly understand how it works
A conventional approach to investing involves a client paying off their family home debt before making investments, but this approach largely ignores tax efficiency.
Debt recycling is a strategy that involves transferring your non-deductible debt of a home loan into a tax deductible debt of an investment loan hence the ‘recycling’.
The primary objective is to reduce the non-deductible debt faster than just making regular repayments, while accumulating wealth to build your asset base and eventually fund your retirement.
Traditionally, people wait until their home loan is repaid before they start investing for the future.
Unfortunately, due to the growing size of home loans, people start investing later in life.
As people are now also retiring earlier, the time between paying off the home and retirement has been eroded, limiting the growth potential of their investments.
Debt recycling strategies challenge traditional financial planning strategies by commencing the wealth creation process immediately.
Using debt recycling, you can simultaneously pay off your home loan whilst maximising your wealth creation potential.
How does debt recycling work?
All surplus cash flow, after the interest is paid on the investment loan (line of credit), is used to reduce a non-deductible home loan, thereby more rapidly increasing equity in the home.
Home loan repayments are ‘Principal and Interest’ while the investment loan payments are usually ‘Interest Only’ to ensure that non-deductible debt repays earlier and deductible debt works to the maximum.
All investment earnings, franking credits, tax refunds and other surplus cash flow, after paying the investment loan interest, should be used to further reduce the home loan and increase equity in the home.
Over time, amounts equivalent to the increase in equity can be drawn down and invested in growth investments further, if desired (depending on your life stage and objectives).
OK so what are the major benefits of debt recycling?
If the above process is repeated over future years in a disciplined manner it can reduce the non-deductible home loan more rapidly, whilst increasing investments into growth assets.
You are able to invest immediately rather than waiting for the mortgage to be paid off.
It allows the power of compounding earnings to start working earlier to benefit from dollar cost averaging.
Dollar-cost averaging involves a client investing the same amount of money at set intervals over a long period, regardless of whether market prices are up or down.
Further, while interest rates are low the return from shares/property will generally beat just paying off debt.
By directing investment and other available income into a home loan, there is the opportunity to reduce it faster and therefore save on interest.
Borrowing to invest can provide tax effectiveness through the deductibility of interest. This will reduce the net cost of the strategy to you. The higher your marginal tax rate, the more profitable this strategy.
Gearing can provide for a diversified approach to create wealth for your retirement.
OK, what are the risks of debt recycling?
While debt recycling does have a number of benefits, there are a few downsides worth considering – especially if your loans are not structured correctly or you don’t have the required income to support the endeavour over the long term.
The number one thing you should know before considering utilising debt recycling is that just as your returns are compounded, so too are any losses you might suffer when markets experience a downturn.
Debt recycling will usually only be recommended as a long-term strategy, allowing you time to recover from any market crashes that occur before you need to access income from your assets. In fact, debt recycling is usually not recommended for anyone with an investment timeframe of less than seven years, with a longer timeframe generally leading to better benefits.
Debt recycling is also a strategy that is usually most effective for those with a strong household secure income who are able to comfortably service both loans and who’ll benefit the most from the tax advantages. Minimum savings capacity would be clients who can save more than $3,000 per month to implement this strategy.
You should also ensure you have enough insurance to protect your income and cover loan repayments in the event of your death or disability.
Investor suitability
Clients who are most likely to be appropriate to consider a debt recycling strategy are those who:
- Have a long-term investment horizon (of, at least, seven years)
- Can tolerate volatile markets and are willing to continue investing during market downturns
- Have good surplus income that will allow them to meet interest repayments, regardless of the amount of income being generated from their investments
- Have the discipline and focus to stick to the strategy long term.
Still Unsure About Debt Recycling? We Can Help
If you’re not sure about whether debt recycling is the right strategy to help you build your wealth and secure a brighter financial future click the image below to arrange a free consultation.
