Debt management can be difficult, especially when you have multiple sources of debt and high-interest rates. You’ve probably heard of the terms “good debt” and “bad debt,” where good debt is an investment in something that grows in value over time and bad debt is spending on items that quickly lose value. But what if you could turn your bad debt into good debt?
This is where the concept of “debt recycling” comes in. This strategy has the potential to reduce your overall debt load while also improving your financial situation.
In this article, we will look at the concept of debt recycling, including its benefits and drawbacks.
What is debt recycling?
Debt recycling is a strategy that aims to help you pay off your non-deductible debt (for example, a home loan) as quickly as possible while also building your wealth in a tax-effective way over time. It entails replacing or “recycling” your home debt with tax-deductible debt from investments.
It’s a viable option for those who are finding smart ways to manage their debt and get back on track faster.
How does debt recycling work?
This strategy involves using the equity in your home to invest in income-producing assets with the potential for growth. The earnings from these investments may be applied to your home loan over time, allowing you to pay it off faster than if you were just making regular payments.
The interest on investment loans is usually tax-deductible, so this strategy has the potential to generate tax savings, which can then be applied to your mortgage. Not only that, but as your new investments increase in value, you will be increasing your wealth at the same time.
Let’s take this scenario as an example: Assume your home is worth $300,000 and your mortgage balance is $150,000. Take note that although you have $150,000 in equity, most lenders will only lend you 80% of the value of your home, minus your mortgage.
80% of $300,000 is $240,000. Take away the $150,000 of your mortgage and you have usable equity of $90,000. Then you take $70,000 of that equity as a tax-deductible investment loan and invest it in income-producing assets like stocks, ETFs, and mutual funds.
Suppose your investments increase in value over the next year and generate a $4000 income. You put that $4,000 in investment income toward paying off your mortgage.
This, of course, increases the equity in your home, and you then take the amount in extra equity and reinvest it in more income-generating assets. Repeat the process until your home loan is paid off completely.
Is debt recycling right for you?
Before jumping into it, check out this list to understand whether debt recycling is the right strategy for your situation. To make a debt recycling strategy work, you’ll have to check off these boxes:
- – Equity in your home
- – A long-term investment strategy
- – Willingness to take on more debt and keep an investment loan
- – Readiness to stand volatile markets and willingness to invest even during market downturns
- – A consistent income generated independently of this debt reduction strategy; enough cash flow to cover your investment loan’s interest payments.
- – Income protection insurance, which can provide replacement income if you are unable to work due to illness or injury
What are the benefits of debt recycling?
Debt recycling, like many financial strategies, can have varying benefits depending on your specific financial situation, income, and future financial goals.
One of the most significant advantages of debt recycling is that it allows you to start growing your investment portfolio and building your wealth sooner than if you took a more traditional approach.
Traditionally, you would pay off your home loan first before building an investment portfolio. However, taking this route means foregoing the returns you would have received if you had begun building your investment portfolio earlier.
Debt recycling also allows you to jumpstart diversifying your investment portfolio. Traditional investment strategies would lock you into one type of investment, such as real estate until it was completely paid off. Debt recycling gives you an opportunity to free up extra money that can then be invested in stocks or other diverse investment assets. Your wealth is spread across multiple asset types and sectors as it grows, protecting it from potential market downturns.
What are the risks associated with debt recycling?
Consider debt recycling as a high-risk strategy because you are investing with borrowed money and securing that debt with your own home. If your investment underperforms or interest rates rise, you could face financial problems or even lose your property.
The first thing you should know before considering debt recycling is that, just as your returns are compounded, so are any losses you may incur when markets fall.
Debt recycling is typically recommended as a long-term strategy, giving you time to recover from any market downturns before accessing income from your assets. It is generally not recommended for anyone with a timeframe of fewer than seven years.
It is also typically most effective for those with a strong household income, who can comfortably handle both loans. Those with a minimum savings capacity of $3,000 per month would be ideal for implementing this strategy.
You should also make sure you have enough insurance to protect your income and cover loan repayments if you die or become disabled.
What are your other options?
If debt recycling is not the right fit for you as either a debt management strategy or a wealth-building method, there are other ways to build wealth using debt. You can prioritize paying off non-deductible debt before investing, or you can look into alternative investment strategies that do not require you to incur new debt. Ultimately, the right debt management and wealth-building strategy will depend on your unique circumstances and financial objectives.
If you’re not sure which approach is best for you, talk to Payment1’s lending team. We can help you weigh your choices and make informed financial decisions. Contact us today to know more about your options for debt management and wealth-building.