In today’s episode, we’re talking about a strategy called debt recycling. You can recycle your plastic and paper, AND also your debt.
It’s a long term wealth building strategy, it’s not an overnight ‘make $1M investment strategy’, but the whole concept is that most people have equity in their homes. For example, in the property that you live in, all of that debt is considered bad debt = non-deductable debt.
Good debt is deductible debt.
So the whole process is turning bad debt into good debt, over the long term. The other premise is investing now rather than waiting. Most people’s whole strategy is trying to pay your home off as soon as possible but it does forego future wealth building.
In this episode we cover:
- What is debt recycling?
- What is good and bad debt – the difference between them?
- How debt recycling works
- Some of the risks and common traps people get themselves into
Remember, this is general advice please don’t take the advice specifically towards your circumstances.
What is good debt and what is bad debt?
Let’s begin with bad debt. Debt is bad when it isn’t deductible. So any of the interest repayments you’re making on the home you live in is considered bad debt. Bad debt is owner occupied and something that doesn’t make an income.
Good debt is debt that someone or something else pays for while being tax deductible to you for any interest repayments.
Debt isn’t the issue. It’s whether or not it’s non-deductible and if you’re the one repaying it, then it’s bad.
A trap people fall into is using debt to buy a vacant block of land they want to convert into an investment property down the track. In this situation, they can’t claim a tax deduction on that property because they’re not making an income from it. So there’s often a trap when taking out a loan to invest, where if it doesn’t earn you an income you can’t claim it as a deduction.
What is debt recycling?
It works by converting bad debt into good debt.
If you have an owner occupied property and you’ve paid down $200k of that mortgage – imagine the original mortgage was $400k. You’re left with $200k or $250k mortgage against your home. You can unlock that additional equity that you’ve paid down. As long as you unlock or refinance that into a separate loan facility, you can utilise that new debt facility and invest those funds into something that produces an income. Then you can claim that interest as a tax deduction while investing now.
It doesn’t need to be big amounts. You can start with $5k or $10k, where you’ve paid that amount. Then you can withdraw that $5k out of your loan and invest it into something that earns you an income.
However, there’s a distinction between margin loans and taking equity out of your property. Margin loans are riskier than home equity debt.
The takeaway point is: don’t over gear or overstretch yourself because you can put yourself in a bad situation.
Unlocking your equity
The first thing you need to do is go to the bank or see a broker and get a separate loan facility and have an offset account on that. Episode 20 goes through it here. You need a separate loan facility for your home. From there, start an investment strategy of unlocking those funds from an offset account.
To break that down, if you’ve got $400k and you’ve paid it down by $200k, you can unlock that $200k to your new investment. Then your income goes towards paying down the original home loan debt and the other $200k gets invested. Then the income from the investment goes towards paying down the bad debt. So it recycles. Basically, your income goes into paying the bad debt off.
Invest in something that’s well diversified. The worst thing you can do it put that $200k into one share because that share might perform really poorly. So if you put it into a lot of quality assets, then you’re much more secure. That income will go straight into the bad loan. At the end of the financial year, you can refinance and reinvest.
Over the long term, these funds will begin to look very attractive and the income you’re making will be far more than what the repayments on that good debt will be even though they are tax deductible.
What are the benefits of doing this?
We’ve spoken about how a home isn’t really an asset if you’re living in it because it is costing you money. This allows you to accumulate growth into long-term wealth building strategies. It takes that concept of investing now instead of later and allows you to diversify. Instead of just having your home as your biggest asset you have exposure to shares and different industries.
It’s also tax effective. For your bad debt reducing it into good debt means that you are still making interest repayments but they go to offset your taxable income.
There are risks in everything in life, but by doing this you could be exposed to volatility. That’s why you want to invest in something that isn’t so volatile.
Borrowing levels and incomes are major risks. Ensure you don’t overleverage yourself. If you’re a short-term contractor or don’t have the best job security this might not be a good idea for you.
Ownership, there are pros and cons for everything, like whose name should you have the loan in. For the purpose of getting those tax deductions, the best thing is to use someone on a high marginal tax rate; however, this can work as a disadvantage when selling so consider this carefully.
Who’s it good for?
- Someone who can take some risk and who will be committed to the strategy for the long term.
- You will lose money if you don’t invest wisely or panic and sell.
- You need a surplus of cash.
- Insuring your biggest asset – your income. Make sure you have insurance in case you are sick or injured to replace your income – this is very important.
Use a variable rate and don’t try and fix it, as you won’t be able to refinance it otherwise.
Debt recycling allows you to invest now, pay down your bad debt and every year refinance the bad debt into the good debt. Overall it will increase the good debt to increase your income.
Remember, this is general advice, please don’t take it into account with your personal circumstances without seeking advice from a professional.
The Rentvesting Podcast, available on iTunes, was created by Red & Co’s Jayden Vecchio and expert financial planner Louis Strange. Together, Jayden and Louis unpack the facts behind the property market, explain what’s really going on & where the market is heading. They believe in challenging the status quo and want to get out there to educate absolutely anyone looking to enter the property market.