July 30, 2012 is_admin

Reduce, Reuse = Debt Recycle

People often ask how they can begin to build wealth for their future when they still have a mortgage.  It is a common thought that you are best to repay your mortgage and then begin to build your wealth.   If you wait until you repay your mortgage before thinking about investing, you don’t give your investments time to grow.

One way you can begin to build wealth while repaying your mortgage is via debt recycling.  To do this you need to:

  • Have attended information evenings to gain knowledge about investing in income producing assets (such as shares) to ensure that you are comfortable.
  • Be able to show that you are able to consistently reduce your current mortgage.
  • Discuss your comfort level with borrowing to invest, to ensure you are well informed.
  • If you are comfortable with borrowing to invest, you use the equity in your home to establish an investment loan (eg. Line of credit)
  • You then work with your adviser to invest a little a lot of your borrowed money into an income producing asset, such as shares (e.g. via managed fund)
  • Use the income produced by your new investment, the tax savings achieved from your gearing strategy and your surplus cashflow to reduce your mortgage.

As you reduce your mortgage, you increase your investment debt to purchase additional investments.  This process is continued until your mortgage is repaid.

Below is a case study to illustrate the benefit of beginning a debt recycling strategy rather than waiting until your mortgage is fully repaid.

Greg, aged 45, and Jackie, aged 44, own a home worth $600,000 and they still owe $300,000 on their mortgage.  Their after–tax salaries are $3,065 and $1,592 per fortnight and their combined living expenses are $4,800 per month.

They want to pay off their home loan quickly.  To achieve their goal, they have been crediting their salaries into a 100% offset account, using credit cards to pay the majority of their living expenses and paying of their credit cards at the end of the interest-free period.

They also want to maintain their lifestyle when they stop working. So, their financial adviser suggests they use debt recycling to complement the wealth they are accumulating in superannuation.

They’re comfortable with a  total debt equivalent to 67% of their home value (ie $400,000) Given they currently owe $300,000, they use the equity in their home to establish an interest-only investment loan of $100,000 and invest the money in Greg’s name in a managed Australian share portfolio.

They also arrange for the investment income and tax benefits to be paid into (and the investment loan interest to be deducted from) their home loan offset account.

At the end of the first year, after reducing their home loan by $42,309, they increase their investment loan by the same amount and use the money to purchase more units in Greg’s share fund.

They continue this process each year until their home loan is paid off six years from now. Then, for the next 14 years, they invest all their surplus cashflow (including the investment income and tax savings) in the share portfolio.

If we now jump forward in time by 20 years, we will compare their position after implementing the above against their position if they waited until they repaid their mortgage to begin building wealth.

After 20 years Debt Recycling Repay home loan then invest
Time taken to repay home loan 6 years 5.7 years
Value of investment portfolio (net of CGT) $2,627,667 $1,911,600
Outstanding Debt ($400,000) NIL
Net position after 20 years (after selling all investments, paying CGT and repaying the loan) $2,227,667 $1,911,600

By using debt recycling Greg and Jackie will have an investment portfolio worth an extra $357,861 after Capital Gains Tax (CGT) and loans repaid – despite taking slightly longer to repay their mortgage.

To discuss how you could take advantage of opportunities available to you, please feel free to come and have a chat with us.

Assumptions: The Australian Share fund provides an investment return of 8.50%pa (split 4% income and 4.5% growth).  Investment income is franked at 75%.  The home and investment loan interest rate is 7%pa.  These rates are assumed to remain constant over the investment period.  Greg earns a salary of $110,000 pa and Jackie earns $50,000 pa. Their living expenses are $4,800 per month.

By Jess Hall, Financial Planner

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