Achieving Financial Freedom with Debt Recycling
Debt can be considered an ugly word.
When it comes to debt, we often think about the negative side. But debt isn’t something we should necessarily run away from.
Whether it be student loans, mortgages, or personal loans, most of us will have debt at some point in our life. Debt is an inevitable part of life, so it’s best we learn how to harness the positives of it.
While managing debt, and even minimising debt as much as possible is generally the preferred approach, debt can also be used as a valuable asset.
A debt recycling strategy is a great example of this, where debt is used to invest in an asset that will generate additional income and provide tax benefits.
There are a range of factors to take into account before considering debt recycling, as it isn’t a strategy entirely free of risk. But for those willing, it can be a great way to maximise financial returns.
We’ll go through some of the ways debt can be used to benefit your financial situation, as well as some of these risks and how they can be mitigated.
Debt recycling: What is it and how can it be used?
As we’ve mentioned, debt recycling is a financial strategy that involves going into debt when investing in an asset, in the hope that the asset will generate income, not only paying the debt, but providing further financial gains through tax benefits.
A common debt recycling example starts through equity conversion, where you convert a portion of the equity in your property into an investment loan.
From here, you take the funds obtained through refinancing your mortgage and invest in income-generating assets. This may include shares, managed funds or more property!
For example, say you have a property worth $600,000 and the remaining mortgage is $250,000. This means you could have up to $350,000 in equity that can be used to establish an investment loan. That $350,000 can be used to invest in those other income-generating assets.
The income generated from that investment is used to repay the debt, such as the home mortgage.
But the benefits don’t stop there. Certain investments in certain countries allow you to receive tax deductions for the interest you pay on the new asset.
An example of this is when you use that investment loan for another mortgage. While you couldn’t previously claim tax deductions on the main mortgage, as it is not an income producing asset, that isn’t the case for the second mortgage.
As you are now investing in an income-producing asset, the interest on the new home-loan is tax deductible. This offers you the chance to claim tax reductions, reducing your taxable income and putting more money back in your pocket.
This debt recycling loan structure can be repeated as well, with a cycle of repaying your non-deductible debt and refinancing your mortgage and repeating the investing process.
This only increases your tax deductions and speeds up the debt repayment process.
For a more in-depth discussion on saving tax and increasing borrowing power, check out the video.
The risks of debt recycling
At this point, debt recycling sounds pretty full-proof. We’ve discussed how it can be repeated to continuously gain tax reductions and pay of debt even faster.
So, what’s the catch?
It’s important to note that there are definitely some risks to be weary of when considering a debt recycling strategy.
- There is always a risk associated with investing. The particular asset you choose to invest in may not rise in value or perform as predicted. This may result in you losing money.
- You also need to have consistent cash flow to service the debt and any associated fees or payments. If income investment isn’t enough to cover the debt, you’ll need to have a way to pay back the loan.
- It’s critical that you carry out debt recycling only when a low-interest rate is an option and where you’re investing at a higher rate of return. As interest rates rise, the debt will increase and become a great burden that could expose you to financial risk.
Capital gains tax is also something to consider when investing in Australia. This is a tax that the Australian Tax Office will apply to the profit from selling an asset such as stocks or property.
The profit made from selling your asset must be declared on your income tax return.
Mitigating the Risk
It’s important to carry out debt recycling monitoring as a means of mitigating this risk.
This involves regularly reviewing the asset and assessing the effectiveness of the debt recycling strategy.
Here are a few things to keep track of to ensure the debt recycling strategy is meeting your investment objectives:
- Returns, dividends, rental income and capital gains will be key indicators of the performance of the investment.
- Track the reduction of non-deductible debt and ensure that payments are made consistently.
- Keep informed on the latest changes to tax laws or regulations to avoid unnecessary surprises.
- Regularly review your cash flow, including the impact of interest rates, to determine that you have enough to cover repayments.
And finally, it’s really important to seek professional advice when necessary. A qualified financial professional or adviser can be the difference between risk exposure and a safe, secure debt recycling strategy.
An expert can help you evaluate your financial position and determine the suitability of debt recycling as an investment strategy.
The right professional advisor will also be in the best position to provide expert advice on tax implications, which can be a tricky path to navigate for even seasoned investors.
They can also help you find the right asset to direct that equity into. They consider important factors and tailor a recommendation based on your goals and risk tolerance.
The bottom line
Debt recycling can be a great way to claim tax reductions and speed up the process of debt repayment, improving your financial position overall.
However, as with any investment venture, it’s important to consider all the risks associated with such a strategy. Seek the advice of professionals and secure your financial freedom!