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Debt recycling: what it is and how it works

There are many ways to grow your wealth and get closer to financial freedom. One such way is through debt recycling. Typically used by advanced investors, debt recycling is a way to turn non-deductible debt into tax-deductible debt, while producing an income.

Here we’ll explain what debt recycling is, how it works, the risks, benefits and who it is most suitable for.

What is debt recycling?

Debt recycling is a strategy that can be used to pay off debt that is not tax-deductible, such as a home loan, while simultaneously growing your wealth. Essentially, it can involve a homeowner using equity in an existing home to purchase some kind of investment asset. This asset could be an investment property, shares, or another asset aimed at creating long-term wealth.

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How does debt recycling work?

Debt recycling can be a complicated process, so if you’re not a seasoned investor, it’s a good idea to speak to a financial advisor before you get started. However, if you want to get a basic understanding of how debt recycling works, here are the general steps involved:

1. Access the equity in your home

To get started, you’ll need to have some equity built up in your property. The lower your loan to value ratio (LVR), the better. If your LVR is above 80%, it’s unlikely you’ll be able to tap into your equity without being charged Lenders Mortgage Insurance (LMI).

2. Borrow against your home

You can then borrow money against this house to start investing. To make the most gains, it’s smart to choose income producing assets, such as shares or an investment property that you can rent out.

3. Wait for the gains

After a little while, your investment will begin producing income which you can then use to pay off your home loan through extra repayments. This will increase your home equity, allowing you to borrow more money for investing purposes.

4. Embrace the cycle

As the cycle continues on, you will ideally end up with just the tax-deductible investment loan that you can focus on paying off. If it all goes to plan, you’ll be generating a passive income, while paying off your debts.

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Is debt recycling worth it?

For the right borrower, under the right circumstances, debt recycling can be very beneficial. It offers a way to build a solid investment portfolio while paying down the mortgage on your home.

Here are some of the main benefits of debt recycling:

  1. Save on tax: this strategy helps turn non-deductible debt (i.e. home loan repayments on a family home) into debt that comes with tax benefits (i.e. the interest on an investment loan).
  2. Exposure to growth assets: debt recycling can give you access to assets you may not have been able to afford without following this strategy.
  3. Passive income: if all goes to plan, you’ll end up generating a passive income through your investments.

Is debt recycling risky?

Debt recycling can present a number of risks and is not a strategy for an investor with a low risk appetite. Debt recycling is dependent on the performance of your investments and you can risk high financial stress.

To minimise the risk, it’s important to very carefully consider your whole financial situation. This means looking at your cash flow, expenses, existing debts and assets to ensure you will be able to make the most out of this strategy. Inexperienced investors should consider seeking assistance from a qualified financial advisor.

Here are some of the main risks of debt recycling:

  1. Poor performing investments: if your investment doesn’t perform well, you’ll have an investment loan to deal with and no returns to help you out.
  2. Taking on more debt: having more loan repayments can become overwhelming if not managed well. Missing repayments or defaulting can put your home at risk, leaving you open to losing everything.
  3. Shifting costs: the cost of this strategy will rise if interest rates increase. You also have to consider any fees associated with getting a new loan.

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Who is debt recycling most suited to?

Debt recycling is best suited to an experienced investor with a high risk tolerance. If you aren’t knowledgeable and confident when it comes to investing but are still interested in this strategy, you can speak to a financial advisor for expert advice.

Using debt to invest can amplify potential losses and gains. Additionally, this strategy operates best when you have at least a few years to see results. It’s also important to have a separate source of income outside of your investments in case things go wrong.

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The information in this post is general in nature and should not be considered personal or financial advice. You should always seek professional advice or assistance before making any financial decisions.

Tags: home loan, interest rate, new purchase, extra repayments, investing, investment, investment loan, investment property, investment return, debt structure, equity, asset

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