What is Debt Recycling? I asked myself the same question when I saw the phrase and discovered it is a rather interesting concept; especially to those that own a home.
Debt Recycling kind of reminds me of a loopty loop process in a fashionable way. The idea is to reduce you non tax-deductible interest on a debt and replace it with a tax deductible interest on another debt.
Here is how it works
Suppose a few years back, you bought the house you live in for $200,000, and now its worth $350,000. First, you would then borrow up to 80% of the equity (or $120,000) as an investment loan. The advantage here is that the loan is fully tax deductible.
Next, you take the $120,000 investment loan and put that to another investment vehicle – usually a managed plan or another property. Then, at the end of the year, the amount you repaid on your mortgage is reborrowed and added to your new investment vehicle. Make sense?
So each year you rinse, repeat and lather – equity to investment vehicle. Now, the advantage to debt recycling is that the non tax deductible mortgage is slowly being converted into tax deductible investment.
Mortgage reduction (‘bad debt’) —-> New Investment Growth (‘good debt’)
When your mortgage is paid off, you can then make the decision to sell your investment and pay off your investment loan, or keep the investment and make payments, or consider taking out a new investment loan against your home and increase or start another investment opportunity (reminds me of a Donald Trump strategy).
But is it right for you?
Many people believe they need to pay off the mortgage before having enough money to build their wealth or make a substantial investment. But the problem with waiting until your mortgage is paid off – your investment will not have time to grow and mature. Debt Recycling allows you to borrow against the equity in your home and make a tax-advantaged investment that can pay off the mortgage and at the same time build you wealth.
So, even though it sounds like a good way to increase your investment portfolio, there are some things to consider before taking part in this strategy.
- Make sure to hire a Certified Financial Planner to help you plan for this type of aggressive financial planning.
- Remember, if your investment falls in value, you end up losing. Do you have the financial cushion to survive the potential losses?
- This is a long-term investment strategy. Do not consider investing less than 5 years of your time with this type of strategy.
- If the interest rates on your loans increase dramatically, the profits decline.
- Tax laws could change, thus damaging your strategy and anticipated profits.
- If you are married, consider obtaining a nuptual agreement with your spouse – you’ve seen the current divorce proceeding with the McCourts – Major league Dodger’s owner, right? Need I say more. I guess, in that case, I should say have one solid nuptual agreement.
- Your assumptions are not fitting the outcome. Much like starting a business, its easy to become overzealous with the potential end results. Thoroughly research your investment opportunities before leaping in. Gain a second opinion from a colleague, a different opinion could help you see all sides of the opportunity.
- Make sure your CFP arranges adequate insurance for income protection, trauma, or death and disability.
Debt Recycling during an unstable economy
Currently, I do not think debt recycling is the right investment planning strategy. The housing market is great for those people that can afford to invest in home forclosures; preferably with cash. There are $500,000 properties being sold for $200,000 in my area right now. I say cash to invest instead of using the equity, because my husband and I were hit hard in this economic downfall. There was a $15,000 of equity in our home that soon skyrocketed to $250,000 equity during the housing boom (that was a nice feeling). But now we were hit hard and the home is valued (minimally) upside down – Ouch.
Now if you take the equity from your home to invest it into a managed investment plan (now its sound like Warren Buffett) – buy low, sell high – could be a consideration.
I would be interested on your take about debt recycling. Neat concept. But too much at risk?
(photo credit: Shutterstock)