When people take out a home loan, most focus on paying off their home loan before they make any investments. However, this method ignores the set up of our tax system and the advantages of borrowing to invest, and this is where the strategy of debt recycling comes into play.
Debt recycling is a strategy used to build wealth tax effectively. Debt recycling is the process of using surplus capital or cash flow to reduce bad debt (inefficient debt) and replacing it with good debt (efficient debt) in the form of an investment loan. For example, the proceeds of the investment loan is used to purchase investments. The idea is that the investments over time will grow and also provide an income to accelerate the repayment of the bad debt.
Good vs Bad Debt (Efficient and inefficient debt)
Your home loan is generally known as bad debt as you do not receive a tax deduction on the interest cost. While debt borrowed for investment purposes is called good debt as you would generally receive a tax deduction for the interest cost.
What's The Impact?
If you have $400,000 of bad debt and you are paying 5% interest the annual cost of that debt is $20,000. If the same loan was tax deductible (good debt) and you were paying 39% tax including the Medicare levy, your after tax cost of that debt would be $12,200. To think of this in a different way, this is equivalent to an interest rate of 3.05% compared to 5%. Therefore good debt is much cheaper then bad debt and a reason why many call debt used to purchase investments as good debt.
Two ways you can implement a debt recycling strategy
Is taking the net proceeds from an inheritance or from the sale of investments or other assets. You can also use the net proceeds from employment bonuses, termination payments or prizemoney to repay any of your loans classed as bad debt or inefficient debt. You then borrow an equivalent amount to purchase investment assets.
This results in the same overall level of debt. However, the investment component of your debt would be income producing and therefore tax deductible. You have decreased your amount of bad debt and replaced it with an equivalent amount of good debt.
If you were to invest the net proceeds directly, none of your debt would be tax deductible.
To accelerate the repayment of bad debt and the creation of wealth you may recycle your debt on a regular basis, this could be monthly, quarterly, six monthly or annually. That is, at the end of each period you top up your investment loan by an amount equivalent to the reduction in your bad debt. The proceeds you receive from topping us your investment loan must be used to purchase investment assets.
This means that you maintain your overall debt level yet continually reduce your bad debt and replace it with good debt. If you continue this process you will eventually extinguish your bad debt and be left with an investment loan with fully deductible interest.
In order to maximise the reduction of bad debt you direct all surplus cash (except for the interest expense on the investment loan) towards repayment of the bad debt. This includes salary, investment income and tax benefits (eg tax refunds and franking credits).
When debt recycling goes wrong!
I have seen first-hand investors implement a debt recycling strategy that goes bad. One of the biggest problems is that they implement the strategy without the due diligence required on the investment itself. People buy investments where the cash-flow generated by the investment is significantly lower than the cost of debt. When this happens it actually reduces the speed of the repayment of bad debt. It also doesn’t matter the investment class, I have seen people buy an investment property that had such a low return that all their surplus cash flow went to maintaining the investment, with none able to be directed to the bad debt. I have also seen the same strategy carried out with the purchase of shares. The problem was purchasing shares that provides a very low-income return or no income. Debt recycling works best when the investment generates income in excess of the interest cost and helps pay down the bad debt even quicker. However, due diligence always needs to be done to have a good idea on whether this is the case.
How to implement a debt recycling strategy:
Having the right loan structure to implement a debt recycling strategy is essential. You need a lender who allows you as you pay down your bad debt and easily increase your investment debt. There are few lenders who do this really well, some lenders have created a very good process but at the same time charge a very high interest rate to implement the strategy, but there are a couple of lenders who do it better than the rest.
The right strategy and structure, are essential. If you would like smart borrowing solutions to help you build your wealth than contact us, at no cost to you.
Debt recycling is only one strategy of many we can help you implement to pay your debt off the smart way.
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