How Debt Recycling Can Help You Build Wealth
Have you ever heard of the term debt recycling? If you have, do you know what it’s for and how you can use it?
Australians appear to have a real love-hate relationship with debt. Everyone seems to agree that debt is terrible… until we’re offered a new credit card with “6-months interest-free”. As a nation, Australians now own a total of 17.7 million credit cards, with a combined national credit card debt of $40.57 billion.
This raises some serious questions about debt management. First of all, is all debt bad debt? How do you tell the difference between good debt and bad debt? What is debt recycling? Can you use debt recycling to build wealth? And how can a Gold Coast finance broker help you achieve an effective debt recycling strategy?
Is All Debt Bad?
It might sound crazy, but not all debt is necessarily bad. Now, not being able to repay your debt – that’s bad. Taking on more debt than you can handle can lead to a bad credit rating and a lot of unnecessary stress. In a worst-case scenario, you could even end up losing your home. But manageable debt that is helping you work towards a specific goal – now that can be a very good thing.
What Are the Different Kinds of Debt?
So, what are the different kinds of debt? While debt comes in various forms, it can be listed in three distinct categories:
This refers to debt that is for essential purposes (i.e., keeping a roof over your head). For debt to be classified as “necessary” it needs to be “reasonable and justifiable” (so, no, a jet ski does not count). Your home loan is a good example of a necessary debt. It’s not tax-deductible, but in the long run, it will result in you owning your own home (an asset that should increase in value over time). Another example would be HECS-HELP debt, which pays for your higher education.
Bad debt is when you owe money, but you’re unlikely to see any real benefit once the loan is finally repaid. Credit card debt is a classic example of bad debt. Generally, you’re paying high interest on items that lose their value very quickly, possibly even by the time you’ve paid off the debt. Other examples of bad debt would include ‘buy now, pay later’ schemes and ‘payday loans’ (where you get a short-term loan with high interest).
Good debt is the kind that can help you achieve your financial goals and build wealth. For example, when you take out a loan on an investment property, you’re gaining debt. But the interest on that loan is tax-deductible (so it’s beneficial now), and it’s paying off an asset that is highly likely to increase in value over time.
What is Debt Recycling?
Understanding the difference between good debt and bad debt is crucial if you want to succeed at debt recycling. What is debt recycling? According to Michael Yardney (a multi-award-winning property investment advisor), debt recycling is “a sound investment strategy” that can help you build personal wealth.
Debt recycling is when you borrow against the equity in your existing property and then use those funds to invest in income-generating assets (such as an investment property). The debt is tax-deductible and provides an ongoing income (usually in the form of rent) which can then be used to cover the mortgage repayments. This cycle can then be repeated once you build up more equity.
Should You Use A Debt Recycling Calculator?
As with any kind of financial strategy, debt recycling involves a certain level of risk. One key element is ensuring that you can manage the added debt successfully. Because of this, some potential investors will use a debt recycling calculator to estimate their potential costs vs. returns.
While an online debt recycling calculator can be useful as an initial indicator, it’s important to keep in mind these tools are generic by design. This means that a debt recycling calculator can’t offer advice tailored to your financial situation.
This is why it’s a good idea to talk to an experienced mortgage broker before you decide to implement a debt recycling strategy.
How Can You Use Debt Recycling to Build Wealth?
A good debt recycling strategy involves taking necessary debt (your existing mortgage) and then using it to create good debt. Basically, the process works like this:
- You use the equity in your existing home as a deposit for an investment property loan.
- You buy an investment property.
- This investment property delivers immediate income (in the form of rental returns), which can then be used to service the loan repayments.
- You continue to pay off your investment property loan while also paying down your home loan. Both properties experience long-term capital growth, increasing the total value of your assets.
- By the time you’re ready to retire, you’ve paid off both loans, leaving you with a home you can live in and an investment property that will provide a steady income stream throughout your retirement.
How a Debt Recycling Strategy Works
This all sounds good in theory, but in practice, what would a debt recycling example look like? Consider the following debt recycling example:
Shannon is a homeowner in Brisbane with a $500,000 mortgage and $200,000 in home equity. Shannon talks to an experienced broker about debt recycling strategies and decides to use the available equity as a deposit for an investment purchase. Shannon buys a $400,000 investment property, rents it out, and uses the rental income to cover the loan repayments.
Over time, Shannon pays off both home loans in full, resulting in a debt-free home and an investment property that now provides an ongoing income stream. This strategic debt recycling approach allowed Shannon to leverage existing debt for wealth creation, which now funds a comfortable retirement. Shannon decides to celebrate by buying a boat.
A Gold Coast Finance Broker Can Help with Your Debt Recycling Strategy
Of course, any kind of significant financial investment should only be made after seriously considering your personal financial situation. But if you’re interested in obtaining an investment property loan and you’re not quite sure where to begin, start by giving me a call on Ph: 0421 934 033 or Ph: 07 5597 6049. As an experienced Gold Coast finance broker, I can explain in more detail exactly “what is debt recycling?” and help you evaluate the various pros and cons of this particular finance strategy.