Unlocking Wealth With The Power Of Debt Recycling
Traditionally, people wait to repay their mortgage before venturing into wealth creation. As people want to retire sooner, this conventional approach limits the growth potential of investments. The concept of debt recycling challenges these traditional strategies. With Ben Travers, Prosperity.
What is Debt Recycling?
Debt recycling involves paying down a mortgage and subsequently borrowing to setup investments such as shares or property. The aim is to use the income generated from these investments and associated tax benefits, to expedite the repayment of non-deductible debt, relying on the growth potential of the investment over time.
Debt recycling enables individuals to start investing now, while simultaneously working to build wealth faster.
How Debt Recycling Works
It is crucial to establish the correct structure from the beginning and we always recommend obtaining professional advice. You may use an existing share portfolio or savings to pay down an existing non-deductible loan (generally on your primary residence), then use your equity or borrow funds to purchase an ‘income producing asset.’ This investment loan is generally tax-deductible, and the income generated is used to pay off non-deductible debt, facilitating a continuous cycle.
Historically, barriers have been arranging this with a bank, keeping finances separate, and general management. Fortunately, with the Lending and Financial Services teams
at Prosperity, the process is streamlined.
Debt recycling works incredibly well during a refinance, mostly for accumulators with steady incomes, who want to get on top of their mortgage.
The following hypothetical outlines a real-world application. James and Sarah are Newcastle GPs in their 40s, both earning $250,000 a year, with a $1.2M mortgage and $150,000 share portfolio. By selling their share portfolio (mindful of capital gains), refinancing their loan, utilising equity and strategically repurchasing shares (depending on their profile), they could see a net benefit of up to $212,000 in year 10. This includes paying off their mortgage two years faster.
Assessing the Risks and Benefits
Debt recycling has different risk levels. If you use cash to recycle debt, then your risk levels should be no higher than using cash to purchase shares in the traditional sense. Should you borrow more than your original loan, then this would be considered a ‘geared investment’ with higher risk.
The potential benefits include tax savings, diversified investment portfolios and accelerating your home loan repayments. When executed correctly, individuals can own their homes sooner, save on tax and build a diversified portfolio.
Risks:
- Investments | The chance investments may underperform.
- Interest rates | Increasing rates affecting gains and debt burdens.
- Cash flow | The importance of maintaining sufficient cash flow to cover debt-related costs.
- Discipline | The need for discipline in allocating investment income and tax savings to loan repayments.
- Insurance review | A thorough review of insurance coverage to protect against unforeseen events.
Benefits:
- Tax advantages | Conversion of non-deductible to deductible debt for tax savings.
- Diversified investments | Spreading investments across asset classes minimises risk.
- Faster mortgage repayment | Utilising home equity accelerates repayment for financial flexibility.
- Compounding returns | Early wealth building allows for compounding returns.
- Tax efficiency | High-income earners can find debt recycling cost-effective, optimising tax benefits.
While debt recycling provides tax advantages through deductible debt, individuals must also consider and plan for potential implications such as capital gains tax.
Is Debt Recycling Worth It?
Debt recycling is a dynamic approach to wealth creation, challenging traditional financial planning norms. While it comes with inherent risks, the potential benefits, including tax savings and accelerated home loan repayment, make it a compelling strategy for those with a long-term focus. This decision depends on individual circumstances. Seeking professional advice is paramount to ensuring the best outcomes and minimising potential pitfalls.
A complex strategy can be made extremely simple when your financial adviser, lending specialist and accountant are all on the same page.
At Prosperity Advisers, we provide tax/ structuring advice, financial advice and lending advice by professionals who are specialists in this area. We recommend reaching out for advice before implementing, to ensure this is the right strategy for you.
Prosperity Wealth Advisers (ABN 32 141 396 376) is an authorised representative of Prosperity Wealth Advisory Services Pty Ltd, Australian Financial Services Licensee (533675).
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