What is it and how to earn money from your debt?
Key takeaways
Turn Your Debt into a Wealth-Building Tool: Debt recycling allows you to convert non-deductible debt, like your home loan, into deductible debt linked to income-generating investments, helping you build wealth over time.
Boost Your Tax Efficiency: By shifting your debt structure, you can reduce your taxable income, leading to potentially higher tax refunds that can be reinvested, further accelerating your wealth creation.
Requires Discipline and a Solid Plan: Debt recycling isn’t for everyone; it demands a disciplined approach to both debt management and investing. A clear plan and regular reviews are essential to keep the strategy on track.
Risks Involved: The strategy comes with risks, including the potential for market volatility to impact your investments. It’s crucial to have a diversified portfolio and a strong risk management plan in place.
Best for Stable Incomes and Higher Risk Tolerance: Debt recycling is most suitable for individuals with stable incomes and a higher tolerance for financial risk, as leveraging debt can amplify both gains and losses.
Seek Professional Advice: To ensure the strategy aligns with your financial goals and risk profile, consult with a financial advisor who can tailor a plan specifically for your circumstances.
You were probably taught by your parents to get a good education, a good job, buy a home, work really hard, and pay off your debt.
But, in my mind, that’s not a productive use of the equity in your home or your investment properties.
Instead, you should recycle the equity in your home and convert it into productive debt to buy income-producing assets.
But before we start delving into all things debt recycling, let’s start out by clarifying the difference between good and bad debt, and how having debt can actually benefit you, and set you on the path to financial freedom.
The three types of debt
- Bad debt:
This is a debt against assets that depreciate in value.
Bad debt generally refers to things like credit cards or other consumer debt that do little to improve your financial outcome. - Necessary debt:
This is the non-tax-deductible debt against your home, but it’s something essential that can’t really be avoided. - Good debt:
This is a tax-deductible debt against income-producing and appreciating assets. Think loans against residential investment properties business loans.
This is the type of debt that can help build wealth and bring you cash flow over time.
Not all debt is bad debt
Somewhere along the line, you were probably taught that debt is a problem.
But, I don’t agree with that.
Having debt is not a problem.
Not being able to repay your debt (or interest on your debt) is the problem and that’s why it’s so important to understand the difference between good and bad debt.
Having said that, in today’s economic environment, I believe good debt is an asset.
Now I know that may sound counterintuitive but let me explain…
During periods of high inflation, inflation becomes a friend rather than a foe for property investors.
While inflation erodes the value of money, it also reduces the real value of debt.
This means the money you owe on your mortgage is effectively worth less over time, while the value of your property—being a tangible asset—tends to increase.
This dynamic creates a dual advantage: your debt gets cheaper in real terms, and your asset grows in value.
So, while inflation may feel like an enemy as it chips away at purchasing power, for those holding real assets like property, it’s also a silent partner, working behind the scenes to boost your wealth.
The trick is to stay invested in growth assets, like property, that not only preserve your wealth but enhance it over time.
And you can accelerate this by using debt recycling.
What exactly is debt recycling?
Simply put, debt recycling is a strategy that turns your current home equity into a tax-deductible investment loan.
If like many Australians you bought your home a while ago and have been slowly re-paying your mortgage debt, and all the while your property has increased in value, you would now have significant equity in your home.
So my suggestion is to borrow against this unused equity and buy an investment property.
Previously that debt against your home was “necessary debt” but re-borrowing or recycling those funds means you now have “good debt” because, as I just explained, you can use this to buy an appreciating asset that will bring in cash flow every month.
But here’s the catch – to recycle your equity into good debt, the debt can’t just be used for anything.
If you borrow against the equity in your home to buy a car or as other debt used for personal purposes, the interest payments are not tax-deductible.
Just to make things clear, it’s not the security against which you borrow the money (your home) that determines if the interest payments are tax-deductible.
It’s the purpose of the loan such as borrowing to invest, which makes interest tax-deductible.
How does debt recycling work?
Debt recycling may be a little confusing, so let’s explain it with a seven-step guide.
1. Over time you will have paid down a portion of your home mortgage with a principal and interest loan and during that time your home would have increased in value.
The difference between the current value of your home and the outstanding amount on your mortgage is your equity.
2. The bank will often lend you up to 80% of the value of your home as long as you can show serviceability.
3. You would take out a new investment loan using your available home equity as security and the purpose of this loan would be to use the funds as a deposit on an investment property.
Imagine your home is worth $1,000,000 and your available equity is $400,000 because you’d paid your mortgage down to $600,000.
You could recycle $200,000 of this equity as a loan – in other words, take out a new investment loan for $200,000 which would be then used as a deposit for an investment property, using the equity in your home as security.
This would leave you with a loan to value ratio of 80% ($800,000 loan on a $1,000,000 property) well within bank lending parameters.
4. You could use this $200,000 to invest in assets that produce both income and capital growth such as a managed fund, shares or as a deposit against an investment property.
5. You could even use the income generated from your investments, plus any tax advantages of a geared investment, to pay off the non-deductible debt in your home loan.
6. Over time you will build your wealth as your investment property or share portfolio should increase in value over time and the cash flow you receive in the form of rental or dividends should also increase.
7. At the same time you will slowly be paying down the mortgage on your home so that when you reach your retirement years and start enjoying the longest holiday you will have in your life, you will own your own home with no debt and have an investment portfolio of properties or shares (preferably both) with a manageable level of debt.
In order for a debt recycling strategy to work you need the following:
- A regular, independent income you can rely on to deliver a surplus cash flow to cover the interest payments on your investment loan.
- A long-term investment focus.
- A willingness to increase your debt and hold an investment loan.
- Tolerance for risk and short-term fluctuations in investment value.
- Income protection insurance—it may provide replacement income in case you’re sick or injured and unable to work.
- And the financial rainy day, cash flow buffer to see you through the ups and downs of your property investment journey – this could be in the form of money in an offset account
So now that you understand a little more about debt recycling, you can see that good debt isn’t really a problem – in fact, you can be an asset.
What else do you need to know
Debt recycling can be a powerful strategy for building wealth, but like any financial approach, it comes with its own set of risks and considerations.
It’s crucial to have a thorough understanding of your financial situation and a clear plan before diving in.
One of the key benefits of debt recycling is its potential to improve your tax position.
By converting non-deductible debt, such as your home loan, into deductible debt, like an investment loan, you can reduce your taxable income and, in turn, increase your tax refund.
This can free up additional cash flow that you can reinvest, accelerating your journey towards financial freedom.
However, it’s important to be aware of the risks involved.
Debt recycling is not a one-size-fits-all strategy and requires a disciplined approach to both debt management and investing.
Market fluctuations can impact the returns on your investments, and if your investments underperform, you could find yourself in a position where your debt exceeds the value of your assets.
This is why it’s crucial to own quality investments, and great assets and even before you get involved in dead recycling start with a strategic property plan to ensure you make the right decisions and avoid the wrong decisions.
Why not work with the wealth planner Metropole who can help you tailor the strategy to your specific circumstances?
Incorporating debt recycling into your overall financial strategy can be a game-changer, especially when approached with the right mindset and planning.
It’s not just about earning money from your debt but also about using your existing resources more efficiently to build long-term wealth.
As with any strategy, regular reviews and adjustments are essential to ensure it remains aligned with your financial goals and risk tolerance.
So why not harness the power of your debt to work for you, rather than against you, and pave the way for a more secure financial future.
