Debt Recycling: Will I be better off financially?

Do you have a property that you are currently living in but are wondering how to maximise your earning potential?

What is Debt Recycling?

Given the low interest rate environment, investors are wondering how they can take advantage of debt to boost their net wealth. One concept that has been being a lot of media attention is debt recycling. Debt recycling involves drawing down on your home loan (equity from a mortgage) that is non-deductible and replace it with tax-deductible investment debt. For instance, the non-deductible loan could be on assets such as your principal place of residence. By investing in income-producing assets such as shares you are funding a new source of income.

Debt recycling can offer a better return on investment (ROI) for the same money that would otherwise be tied up in the equity of your home. Whether you choose to invest in shares, property, or a new business venture, make sure that it is income-producing. However, if you choose to invest the money make sure that you are first paying off the non-deductible debt. The reason is that you will already be entitled to an interest deduction from a loan on an investment property. On the other hand, you may also be considering upgrading your property for future investment purposes. If debt recycling isn’t a viable option, make sure you get a free property appraisal to see what your property is currently worth. As this is an affiliate link I would receive a small commission on the referral.

Maximise property earning potential

To maximise the property’s earning potential it is important to consider all aspects of life and expense. When debt recycling, interest-only loans offer a more tax-effective alternative than principal and interest loans. By paying down a larger amount of the interest component you can redirect your funds to your online brokerage account. However, funds that are being aggressively contributed to pay down the mortgage could place undue stress on your finances. Most investors have conflicting priorities as to where the cash flow is most needed. School fees, rent, utilities and child care payments are expenses that could be an issue if the budgeting is overlooked. If you are wanting to track your income and expenses have a look at the Wage Investor Budgeting Schedule to get you started.

Managing Debt Effectively

There are both advantages and disadvantages to taking on debt to fund an investment. I have summarised the key pros and cons to debt recycling below:

Pros

• Potential for increased growth and capital in a rising property market
• Low cost of debt in a low interest environment
• New income source
• Offset accounts can reduce the interest you pay on your home loan
• Tax effective method of investing

Cons

• Increase potential downside risk in a falling property market
• Greater exposure to higher interest rates
• Increased financial complexity with new investment
• Greater compliance costs
• Strict budget required to manage your money

Debt Recycling: FAQ

Is it better to pay off the mortgage and add funds to offset the account while interest rates are so low? Or should I draw the funds out invest in ETFs? What path have you chosen and why?

On the one hand, the funds could be added to an offset account to reduce the interest owing on the loan. The advantage is that the mortgage interest will be dramatically reduced on the principal place of residence in the long term. However, if the loan is against an investment property the high interest could provide a tax deduction. Therefore it is important to consider your overall financial position not just from a cash flow or tax viewpoint. To help manage your money better have a read of the following WeMoney Review. If you are deciding whether to invest in Exchange Trade Funds or property join the shares vs property discussion.

Debt Recycling Summary

When considering whether to draw down on your equity first assess whether the investment is secure. For instance, drawing down on volatile shares could expose you to a potential market downside. Moreover, getting a call on your margin loan could require you to sell at the bottom of the market cycle. This would have crippling effects on managing your debt effectively. However, debt recycling can offer a faster way to pay down your home and invest the savings to produce income. Therefore, consider your personal circumstances to see if this strategy is right for you. Consult a financial planner or accountant if you are unsure of the best strategy to adopt. If you would like to learn more tips on managing your money, see how you can earn yourself a cheap holiday.