What Should You Know About Debt Recycling?

Shakira
Post : November 3, 2022

What's debt recycling? We all know what debt means but have you ever heard the terms "good debt" and "bad debt?." Well, good debt increases in value over time and bad debt is something that loses value. The concept of converting bad debt into good debt is known as 'debt recycling. This helps to improve the financial situation by reducing the debt burden.

If this is a perfect idea to achieve your financial goals, read this article further as we explain everything you should know about debt recycling. 

What is Debt Recycling?

Debt recycling is a procedure that focuses on helping you to pay off your home loan (non-deductible debt) as early as possible. Over the long term, it also helps to build up your wealth in a tax-effective way. 

This process is known as recycling your debt with tax-deductible debt through investments which can reduce your overall burden. The idea of debt recycling is that you make your loan repayments using investment income. This way, the loan can be paid off much faster than if made through regular monthly payments. 

Not only does the debt recycling process help you to pay off your home loan, but as the new investments grow in value, so does your wealth, even as your mortgage is paid off. You can also borrow more money as you increase the equity. There are many ways to attain financial freedom and grow your wealth; debt recycling is one such way. 

How Does It Work?

If you are not a seasoned investor or yet to know more about investing, then debt recycling can be a much more complicated process for you. Before you start, it's always best to consult a financial advisor. To help you understand better how it works, let's take a more detailed look into the essential steps involved. 

  • Access your home equity

For starters, you need to accumulate some equity in your property. It is better if your Loan to Value Ratio (LVR) is lower. If in case your LVR is above 80%, you will only be able to tap into your equity if you are charged. With a higher LVR amount, you will only be able to access your equity after paying Lenders Mortgage Insurance (LMI).

  • Borrow funds against your home

You borrow money against your home and invest in income-producing assets such as income properties that can be rented out or even shares.

  • Wait for the income

If your investment is made right, it will start producing income. This extra money can be used to pay off your home loan. As this increases home equity, you can now borrow more money for investing purposes. 

  • The cycle continues

As the cycle continues, you will end up with only the tax-deductible investment loan you need to pay off. If all of this goes on as planned, you will generate passive income while you pay off your debts. 

Benefits of Debt Recycling

  • Reach life goals much faster 

Wealth creation can be kickstarted immediately by using this process. You can simultaneously attain life goals much faster with this strategy as you pay off your home loan.

  • Faster Wealth Creation

The debt recycling process helps with faster wealth generation, which helps to sustain long-term investment growth. You also can access liquid assets when necessary.

  • Diverse Income Portfolio

With the debt recycling strategy, you will have access to plenty of assets that otherwise you wouldn't have been able to afford, and it also generates passive income through investments. You also get to enjoy compounding returns and a diverse asset base which insulates you from future market downturns.

  • Tax Advantage

The greater the marginal tax rate, the more profitable it gets. You can convert the non-deductible debt into debt with tax deductions through the debt recycling process. 

Is Debt Recycling the Right Fit For You?

It can be an effective strategy to achieve your financial goals. Below are a few checkpoints to ensure that debt recycling is worth it and the right fit for you.

  • Long-term investment
  • A regular income
  • Homeownership or equity in your home
  • Tolerance for risk
  • A surplus in cash flow

Risks and Other Important Things You Should Consider 

However, it does have a number of risks. To reduce the risks, you must carefully consider your financial situation to make the most of this strategy. It includes looking at your expenses, cash flow, debts and assets. Some of the main risks are:

  • Market fluctuations

Borrowing money for investing in falling markets can lead to risks. As you still have to repay your loan, your losses will increase significantly. 

  • Taking on more debt

It can be overwhelming to have more loan repayments if not managed well. You may even end up losing everything if you miss repayments. 

  • The value of assets dropped

If there is a drop in the asset value of the purchase with borrowed funds, you will have low or no returns to repay. You may also end up in debt even after selling off the asset. 

Conclusion

As you know now, there are pros and cons to debt recycling. Calculating and comparing home loans can get complicated if you do not have a finance background. So it's vital you understand that debt recycling is not for everyone. If you consider debt recycling the right strategy for you, then it is time to seek financial advice on how to proceed with the procedures. 

If you do it right, debt recycling can be profitable and also a tax-effective strategy that helps to pay your mortgage much faster while at the same time building investments. But don't fret if you don't feel like it's your thing. Afiyah Financial Services can help you secure home loans without jeopardising your belief. Or, if you don't want to handle interest, we have a way for you. Talk to our team to get your Islamic home loan quickly, easily, and in a halal way! 

 

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