How Does Debt Recycling Work? Benefits, Risks and Strategies

Apr 3, 2024

What is Debt Recycling?

Debt recycling is a financial strategy that converts non-tax-deductible debt, like a home mortgage, into tax-deductible debt linked to income-producing investments. This process aims to reduce overall debt, grow wealth, and improve tax efficiency.

The income generated from these investments is then used to pay down the original non-deductible debt. At the same time, interest expenses on the investment loan may become tax-deductible, potentially reducing your overall tax liability.

The goal is to accelerate wealth accumulation and debt reduction simultaneously, making efficient use of personal debt to enhance financial growth.

 

Good Debt vs Bad Debt

 

Good DebtBad Debt
Purpose: Invested in assets that can potentially increase in value or generate incomePurpose: Used for purchases that lose value quickly and do not generate income
Examples:  Mortgages for property investment 

Student loans for education 

Business loans

Examples: Credit card debt for consumer goods 

High-interest personal loans for depreciating assets

Interest Rates: Often lower, reflecting the lower risk to lendersInterest Rates: Usually higher due to the higher risk of unsecured borrowing
Tax Implications: Interest may be tax-deductible if the debt is used to generate taxable incomeTax Implications: Interest is generally not tax-deductible
Long-term Impact: This can lead to wealth accumulation and financial growth. Long-term Impact: Can reduce financial flexibility and increase financial strain

 

How Debt Recycling Works?

It works through a multi-step process to transform non-tax-deductible debt into tax-deductible debt for wealth creation and efficient tax management. Here’s a breakdown of how it operates:

Identify Non-Deductible Debt: 

The process starts with existing non-tax-deductible debt, typically a home mortgage, where the interest payments are not tax-deductible.

Equity Utilization: 

You leverage the equity in your home or another asset by borrowing against it to create an investment loan. This loan is used for income-producing investments, making the interest on this loan potentially tax-deductible.

Investment: 

The borrowed funds are then invested in income-producing assets such as shares, property, or managed funds. These investments are selected to generate a return that exceeds the cost of the investment loan.

Use Investment Returns: 

The income generated from these investments, such as dividends, rent, or interest, is used to service the investment loan and, importantly, to make additional repayments on the original non-deductible debt.

Debt Conversion: 

Over time, as the non-deductible debt decreases and the investment portfolio grows, you gradually convert high-cost, non-deductible debt into lower-cost, tax-deductible debt.

 

Benefits of Debt Recycling

 

Tax Efficiency: 

By converting non-tax-deductible debt into tax-deductible debt, you can reduce your taxable income by deducting investment loan interest.

 

Wealth Accumulation

It can accelerate wealth building by allowing you to invest in income-producing assets sooner, leveraging time and compounding returns.

 

Debt Reduction

It enables more efficient reduction of non-deductible, high-interest debt like a mortgage, as investment returns can be used to make extra repayments.

 

Improved Cash Flow

The strategy can improve cash flow through tax refunds or deductions associated with investment debt, which can be reinvested or used to reduce debt further.

 

Financial Flexibility

By growing an investment portfolio alongside reducing non-deductible debt, you increase your financial assets and options for the future.

 

Portfolio Diversification

Investing in different asset classes like stocks, bonds, or real estate spreads risk and can provide more stable returns over the long term.

 

Risks of Debt Recycling

The risks associated with debt recycling include:

Market Risk

Investments may lose value, affecting the strategy’s effectiveness and potentially increasing your financial burden if investment returns are lower than the interest on the borrowed funds.

Interest Rate Risk

Rising interest rates can increase the cost of the investment loan, eroding the strategy’s profitability and increasing the financial strain.

Tax Risk

Changes in tax laws could affect the tax deductibility of interest on investment loans, impacting the overall tax efficiency of the strategy.

Complexity and Management Risk

It requires careful and ongoing management. Missteps or lack of understanding can lead to financial losses or inefficiencies.

Leverage Risk

Using borrowed money to invest can amplify gains and losses, potentially leading to significant financial distress.

Liquidity Risk

In times of financial need, you may be unable to quickly or easily sell your investments at a favorable price to cover the loan or other expenses.

Long-term Commitment

The strategy involves a long-term perspective. Short-term market fluctuations can adversely affect the strategy’s outcome if there’s a need to liquidate investments prematurely.

 

Debt Recycling Strategies

These strategies involve carefully planning and executing steps to convert non-deductible debt into tax-deductible investment debt to build wealth and reduce the non-deductible debt over time.

Here are key strategies for this process:

 

Equity Drawing: Utilize the equity in your property to secure a line of credit or loan for investment purposes. The aim is to draw equity as your property value increases or you pay your mortgage.

Investment Selection: Choose investments expected to generate a reliable income stream, like dividends or rental income, and have the potential for capital growth. Common options include shares, managed funds, and investment properties.

Income Reinvestment: Use the income generated from your investments, like dividends or rent, to pay down the original non-deductible debt or to reinvest into further income-producing assets.

Lump Sum Strategy: This involves using a large sum of money, which could come from savings, a windfall, or the sale of an asset, to make a significant investment or to pay down existing non-deductible debt before recycling it into deductible debt.

  • Immediate impact on reducing non-deductible debt or building an investment portfolio.
  • Potentially quicker wealth accumulation due to a larger initial investment.

Monthly Strategy: This approach involves monthly payments towards your non-deductible debt or investment.

  • Lower entry point, making it more accessible.
  • Spreads risk over time, lessening the impact of market volatility.

 

The lump sum approach can accelerate this process but requires a significant upfront investment. In contrast, the monthly strategy is more gradual but can be more manageable and less risky over time.

When choosing between these strategies, it’s essential to consider your financial situation, risk tolerance, and investment goals. Consulting with our financial advisor can provide personalized advice tailored to your circumstances.

 

Is Debt Recycling Worth it?

It can benefit those with a stable income, comfortable with investment risks, and seeking to grow their wealth while managing debt. It’s essential to weigh the potential returns against the risks and costs.

 

Final Thoughts

Consider your financial situation, risk tolerance, and long-term goals. It suits individuals with:

  • Significant non-deductible debt.
  • Comfort with investment risks.
  • A long-term investment horizon
B M Peachey

B M Peachey, has over 15 years of experience investing in property and the stock market, in both New Zealand and Australia. She has a post-graduate degree, with qualifications in Finance and Mortgage Broking and in Accounting and Bookkeeping. She is passionate about ensuring people have access to credible, reliable, and easy to understand information to help them get in control of the life they REALLY want to live.<

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    Disclaimer: The information in this article is general in nature as it has been prepared without taking account of your specific objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstance before acting on it, and where appropriate, seek professional advice from a finance professional such as an adviser.