Paying off the home is an important milestone, but if it means for the next 15 – 20 years you do nothing else, then you could be limiting the growth potential of your personal finances.
For many Australian’s wealth is concentrated in the family home. Establishing other investment strategies while still repaying your home loan can prove almost impossible unless you’re able to think like the wealthy…
Debt recycling is an efficient means for improving the performance of your personal finances beyond traditional debt reduction strategies, which focus solely on reducing existing debt without looking at investment strategies.
Debt recycling is a three-tiered financial strategy that aims to…
- Reduce your home loan
- Minimise interest and tax payable
- Generate future wealth
And this can often be achieved without drastic changes to current lifestyle or spending habits.
Components of an Effective and Sustainable Debt Recycling Strategy
In the weeks leading up to this article I posted a number of articles that explain the process my Wealth Planning team use to improve the personal finances of our clients.
Each article provides a deeper understanding of the components of debt recycling that are essential to reducing debt while building wealth; in addition each article provides insight to different options available for improving your personal finances.
Cash Flow Management
If this is your first time on the Nexus Private website, I recommend having a quick look through the above articles prior to proceeding, it will make the following debt recycling example that much more valuable.
Not all examples are created equal
Beware the fine print: There are examples out there that exaggerate the performance of debt recycling by hiding additional cash flow to inflate performance.
In the below example we demonstrate how reducing debt and building wealth is achievable for the average Brisbane family without requiring additional cash flow.
The example figures my team have used are based on the average Brisbane property value of $580,000(The Real Estate Institute of Queensland March quarter Market Monitor), the average mortgage of $322,000(ABS data end of 2013), a home loan with 20 years remaining and mortgage repayments consistent for each example.
We have taken a very conservative approach in demonstrating Debt Recycling, their are additional options available for improving debt reduction and wealth accumulation performance which we’ve included after the comparison.
How debt recycling works
Most banks are prepared to lend up to 80% of the value of your home – for a home worth $580,000 (as it is in this example) the bank may lend $464,000, subtract the mortgage of $322,000 and you are left with $142,000 of available equity.
The available equity in your property is used as security for an investment-purpose loan; the borrowed money is used to invest in income-producing assets such as managed funds, an investment property or shares…
The income generated from your income-producing assets, plus any tax savings that result from a geared investment, is used to pay off non-deductible (bad) debt in your home loan.
As your non-deductible loan is reduced, more equity becomes available, this enables you to increase your investment-purpose loan by the same amount that you have paid off the home loan, and reinvest in to more income-producing assets.
This process is repeated each year until your deductible loan (good debt) entirely replaces your non-deductible loan (bad debt).
This strategy is not suitable for everyone so it is essential you seek good financial advice before commencing a debt recycling strategy.
Debt Recycling – A Long Term Wealth Building Strategy
To illustrate the long-term benefits of this strategy on reducing debt and building wealth we compare two approaches…
- The standard approach to managing a home loan – regular monthly repayments made for the 20-year term of the mortgage.
- The debt recycling approach – The same regular monthly repayments contributed to a debt recycling model.
The Financial Assumptions for Both Approaches
- Opening loan was $464,000 (80% of $580,000) and has been paid down to $322,000
- Mortgage Interest Rate = 5%
- Household Income = $100,000 indexed at 3% p.a.
- Marginal tax rate = 39% (37% plus Medicare levy)
- Household expenses $47,840 (indexed at 3.50% p.a.) leaves no surplus income available for additional monthly contributions to either example
Applicable to the Debt Recycling Approach Only
- All investment income and tax savings are paid into the home loan each year
- Spare equity is calculated annually and is drawn as an investment-purpose loan and invested into the portfolio
- In the debt recycling example once the home loan is paid off the equivalent repayment amount is contributed to the portfolio
Financial Comparison – Year One
Financial Comparison – Year Five
Financial Comparison – Year Ten
Financial Comparison – Year Fifteen
Note: If your primary goal is reducing debt, at the end of year 15 investment value exceeds the combined total of good debt and bad debt. Selling investments and paying off both debts would result in your home being completely paid off 5 years sooner.
Financial Comparison – Year Twenty
Financial Comparison – On Completion
Investment performance assumptions
Managed Portfolio Income = 4.12% p.a.
Managed Portfolio Growth = 4.02% p.a.
Managed Portfolio & Advice Fees = 1.60% p.a.
Additional Options for Improving Debt Recycling Performance
The example provided above is debt recycling in its purest form, depending on your personal financial situation and goals there are options available that may deliver results better suited to your requirements, these include…
- Depositing all savings and paying all income into an offset account, this will reduce the home loan interest payable.
- Contributing surplus cash flow to the home loan will reduce the home loan interest payable and increase the available equity enabling more of the bad debt to be transferred into good debt and investments.
- Having your home revalued every 2 – 3 years can free up more available equity enabling more investments to be acquired through tax-deductible borrowing.
- If your priority is investment growth, investment income can be reinvested instead of paying down bad debt to compound investment growth.
Who can benefit from Debt Recycling…
This strategy may be suited to individuals and families with a mortgage looking to establish an investment portfolio (such as managed funds, shares or property) at the same time as paying down your mortgage.
There is a degree of complexity establishing a debt recycling strategy and for this reason we recommend obtaining financial advice before proceeding.
At Nexus Private our 6 step financial advice process focuses on your complete financial position enabling our team to quickly assess the suitability of debt recycling, along with over 50 additional financial strategies for the improvement of your financial position.
The best time to start is today, the best way to start is with a Free Wealth Review Session…
FREE PERSONAL WEALTH REVIEW