Good & Bad Debt: Debt Recycling Guide

good debt and bad debt. Debt Recycling

Debt recycling is a fancy saying that started in the financial planning industry.

It was used as terminology so that the consumer thought they were getting something amazing.

debt recycling

However, anyone can implement this strategy. You do not need a financial planner or advisor.

However, you can get in trouble very easily with mixing debt types which can make it a nightmare for your accountant to work out the right tax deductions.

Also, we will discuss the good and bad types of debt. You must know about each of these, before getting involved in debt recycling.

[Remember this isn’t without risk, each person has a different risk tolerance, and it uses the power of leverage to help achieve financial wealth faster.]

debt recycling risk

If you cannot stomach the fact you will be using debt to finance investments and to help pay off “non-deductible debt” (don’t stress we will explain the entire process in detail). Then this may not be for you.

However, if you’re a driven individual whose goal is to provide for your retirement and future. Debt recycling or a variation of it could be suitable for you.

The following questions will be answered in detail within this article;

  1. Good Debt?
  2. What is bad debt?
  3. How can I tell between deductible and non-deductible debt types?
  4. What is debt recycling, how does it work & is it an appropriate strategy for you?

After you finish reading this article, I guarantee you will be able to answer the above questions in detail and hopefully it changes your thinking on what success looks like.

What is good debt?

good debt vs bad debt

When we talk in terms of good & bad it’s easy to recognize the difference.

It is black & white.

Now with debt, it’s not as simple. However, there are easy ways to look at debt to categorise them into the good vs bad options.

Now for something that goes against the grain and conventional thinking.

Your home loan isn’t a good debt! What? Why? Well, I’ll get to that.

What I’ve done is to create a completely new category of “neutral debt”. Whereby, your owner-occupied debt falls into this neutral category. You might not agree with me, but hear me out and then decide.

If you’re unsure if you’re current mortgage is suitable for your goals, check out our previous article which will explain how to review your mortgage, and if you should refinance. Click Here.

Good Debt

good debt

Debt can be good when it’s used to improve your financial situation.

The problem is that many people attribute the feeling of “Good” when they buy superficial things rather than the financial “good” of doing so.

This is why the phase of keeping up with the Jones’s is one of the most dangerous things.

Peoples fear of looking poor, or not successful. Triggers them to purchase things that give a certain look. But have a very detrimental financial effect on them.

We can place good debt into 4 separate categories.

  1. Education
  2. Investment
  3. Business Ownership
  4. Debt Consolidation

Education Debt

Now, this debt could very easily fall into the bad debt column, however, if the purposes of the educational debt are to improve your chances of employment or to further your career it’s good.

On the other hand, If you just finished school and went to university/college because your parents told you to. Then there’s a good chance you’re wasting money and racking up debt.

Did you know that 35% of all students that enrol never finish their degree…

That means that 3.5 out of every 10 students are accumulating education debt. Basically, that’s turned into bad debt as they never finished their degree.

That’s not a great way to start your adult life.

So education debt is good debt as long as it’s followed through and it’s for a purpose of furthering your career.

Investment Loans

Now when talking about investment debt as a good debt we aren’t talking about borrowing to day trade, or to take high speculative investment risks. Such as bitcoin predicting etc. That’s gambling.

We are talking about the 2 main investment platforms where most people have created their long term wealth.

  • Property Market
  • Share Market
Investment Loans Are Good Debts

Borrowing to invest is a very common, wealth creation strategy.

It’s usually implemented when a person believes that the costs of borrowing & holding costs of the asset are less than the ultimately realised profit that the asset generates over time.

This can be from paid returns & future capital growth of the asset.

The most common type of investment loan is a loan that’s borrowed against an asset like property. This ensures you get the lowest possible interest rate.

Also, one thing to remember is that when borrowing money it doesn’t matter what asset you use as security for the loan. All that matters is the purpose of the funds.

So if you’re borrowing against the equity of your current owner-occupied property and using these funds to start a share portfolio. It’s important to keep these loans separate, as the one for investment will be tax-deductible. Never, ever mix non-deductible and deductible debt.

Property & Shares Are The Most Common Investments

property investment and good debt

Now, why is property & shares the most popular investment strategy? Simply because of the consistent long term annual growth of these asset classes.

Property has consistently achieved 7%+ return per annum & the share market has performed over 10% per annum since it’s inception.

It’s important to remember these are long term investment plays. You can have years of negative growth, with years of substantial growth. However, over the course of each 10 year period, you can be safe to assume the above returns.

Now, to show you the power of the property & share market.

The below graph shows if you were to invest only $100k in either shares or property over a 30-year time frame.

Now, obviously obtaining a property for $100k or less these days wouldn’t be practical, however, that’s where the power of leveraging comes in. Using investment loans as ‘good debt’ to invest in your future.

property investment
Property & Share compound growth over time

There are so many different types of property investment strategies available. Sign up to our free membership to receive more information about property investment strategies. Click Here

Business Ownership/Investment

Business debt is good debt, as it’s an investment into your income and future wealth.

You can use your own property as security for the loan or you could look at funding the business through a variety of other methods.

Borrowing against your property will have the advantage of a lower interest rate than any other method of business loan.

It’s a lot harder to gain wealth working for someone than it is to work for yourself. Business ownership is one of the single most important factors in creating sustainable long term growth.

Not that you can’t achieve financial wealth being an employee, it’s just a lot harder.

Debt Consolidation

Now, debt consolidation is more of a strategy to reduce the bad debt down. Rather, than being a “good debt”.

The reason that I’ve included this into the “Good Debt” section, is that it’s a huge step forward in the right direction.

Now you may still have bad debt but by restructuring this debt you could save thousands if not tens of thousands in interest.

bad debt
Racking up debt on depreciating items

The problem is that we live in a world of instant gratification.

Everyone wants to have everything now… It’s no wonder that we are experiencing the highest levels of consumer debt ever!

People are living above their means and accumulating debt that isn’t for their future wealth.

Now, I’m sure we’re all guilty of indulging in something that we didn’t necessarily need… I know I am.

However, it’s the continued cycle of spending that is leading to the highest rates of bankruptcy we’ve ever seen.

If you have been struggling with debts for some time and not sure what avenue to take check out The Bankruptcy Teams detailed article HERE – It could help.

Debt Consolidation Options

Now to consolidate debts, basically the goal is on two fronts

  1. Gather all high-interest consumer debt into one easy to manage lower repayment
  2. Ensure that the interest rate and terms are much more beneficial

You can either look at accessing your properties equity and consolidating your debt into this loan. This is the best option if it’s possible for you.

Alternatively, you can apply for an unsecured personal loan through a company like Quick-Loans. Both options can work for you, as long as you can save money and create a better and simpler structure.

This means you’re going in the right direction.

bad debt

Bad Debt

Bad debt is any debt that isn’t contributing positively to your financial future.

Think of it as debt that’s not backed by an appreciating asset.

If you’re unsure of what we are talking about, scroll back and read the section about good debt first.

Now the biggest culprit of this is the Keeping Up With The Jones’s saying. People want to look successful to their friends and family.

Whether it’s. Clothes, shoes, accessories, cars, holidays just to name a few of the things people spend money on that doesn’t provide a positive benefit to their financial future.

The best example out of them all is cars.

Now. Let’s consider you have a car loan and your monthly repayment is $475 a month. Most people will upgrade their car every 3 – 5 years so this repayment continues (it usually increases).

If people cared more about their future financial success than looking good. Everyone would drive sub $10k cars that they could pay cash for. It’s only our egos that get in the way of our success.

Say instead of paying $475 a month for your car, you instead invest that money. Let’s say in the share market.

Over a period of 30 years, you will crack $1million with just having spent $475 a month or $171,000 in total and received more than $900,000 in interest/share growth.

Invest instead of paying a car loan

bad debt & good debt

So that monthly car repayment is actually costing you $1 Million in retirement. Ouch!

You can use this same approach for any type of bad debt to work out what it’s “actually” costing you. bad debt

It’s not just the amount per week/month/year. It’s the opportunity cost of you not being able to then put that money into an investment opportunity.

That new iPhone you “had” to have rather than the $250 Chinese oppo option. the expensive data plan rather than the pre-paid sensible one.

Every decision you make that’s not giving you the best chance of self-funded retirement is holding you back.

Now, I’m sure you now understand why bad debts BAD.

Deductible Debt vs Non-Deductible Debt

Ok, so there’s a big difference between a tax-deductible debt and a non-tax deductible debt. However, they are very easy to tell apart.

Firstly, you need to understand that with a deductible debt the borrower is allowed a tax deduction for the interest paid against that debt.

deductible vs non-deductible debt

With a non-deductible debt, the borrower must pay the interest with after-tax money.

Now if the loan was borrowed to investment purposes and you receive a return on that investment either through rent received for a property. Or shares held. You can claim the interest as a tax deduction.

However, if the loan is for your home, car, holiday or other personal use “other” than the investment you cannot claim the interest as a deduction.

So, it’s easy to see why people love deductible debts, as it allows you to invest and create wealth and offset some of the associated interest costs.

This is important to understand when we go into the discussion of debt recycling and how this strategy works.

Debt Recycling

If you’re unsure of what exactly debt recycling is and how it works, then read on. We will go through the ins and outs of the strategy.

Like any strategy, there’s pro’s & con’s & debt recycling is no different than anything else in this regard. I’m going to give you my unbiased review and hopefully, it helps you with determining if this is a strategy that you might be able to utilise for yourself.

What is debt recycling?

debt recycling

This strategy works in a few different ways, however, the main idea is the following:

To use investment incomes to paydown / offset non-deductible debt to reduce this debt down faster while growing your wealth

Now if you’re still unsure, that’s completely ok. I’m going to explain it in detail and give you examples of it in action.

You can use this strategy for many different investments, however, to keep the explanation simple I’m going to focus on property investment. As that’s my main knowledge area.

So our goal is to recycle non-deductible debt with an investment property. I’m going to answer the following questions for you.

  1. How does the process work?
  2. What are the risks?
  3. Should I do it?

How does the process work?

The process of how debt recycling works is pretty straight forward.

The idea is to set up an account (offset/Line of credit) that is against your non-deductible loan. I.E Your Home Loan.

You then use this account to put all your income into.

Then, you use this account to pay all of your loan expenses from your home loan to your investment loans.

The idea is to keep as much money in this account for as long as possible to offset the interest charged for that non-deductible debt loan.

Why do you do this?

Because, how offset/Line of credit accounts work is that interest is calculated daily. So the more funds you have in the account throughout the month the lower the interest component will be, and the greater the principle amount paid off.

Offset mortgage account example

So, as you can see here with the image on how an offset account works.

If you have a loan of $150,000 which we labelled (mortgage). You have $20,000 sitting in you offset account.

As you can see the “actual” balance the bank charges interest on is $130,000.

This is why it’s important to use your offset for all your income. Even if your income only sits in there for a week before you have to take it out to pay for something.

For that 1 week, you have saved yourself interest. And as you will see further on, little bits add up to many years in time saved on your loan.

One thing to remember is that if you have your current home loan set up as Principle & Interest, which you should. Then your total repayment won’t actually decrease. Even though the interest calculated is less, you still have to pay the same amount.

Rebalance Your Mortgage Payment

Principle & Interest rebalance

What I mean when I say that is, when you originally take out a home loan. Your initial repayments have a lot of interest and you only pay a small amount of principal off.

By using your offset account correctly you can rebalance the amount of interest and principal you pay.

As you can see by the image, the less interest you get charged the more principle you pay off.

This then reduces your overall home loan balance down faster. Thus, saving you years off your loan.

Debt Recycling with an Investment Property

Now for a more detailed explanation, which shows how the entire process works with the cashflow.

As I mentioned my example will be geared around property investment as that’s what I’ve advised on for many years.

Let’s assume you have bought an investment property for $500k.

What you do is set up a 2nd loan against your current home loan as the deposit + costs for the new investment ($120k). You then set up the remainder of the loan $400k against the investment property.

So what we have now are 3 loans.

  1. Current loan against the home – non-deductible
  2. new deposit & costs loan against the home – tax-deductible
  3. new loan against the investment – tax-deductible

The most important part of this strategy is to identify any new income sources.

  • Rental Income from the property
  • Tax savings

What we recommend when using this strategy is to complete PAYG withholding variations. This means you can pay less tax for each pay cycle. Which increases your take-home salary and helps to reduce non-deductible interest.

If you’re not aware of how PAYG withholding variations work Click Here, the ATO has a detailed overview of the process.

Debt Recycling Example

So let’s assume it’s a couple in this example.

Before the property they had 2 sources of income

  • salary person 1
  • salary person 2

After the purchase they now have 4 incomes going into the offset, which helps offset non-deductible interest

  • salary person 1
  • salary person 2
  • rental income
  • tax variation income

Now you can see below how the loans are structured and how the incomes flow into paying off the non-deductible debt. This is called a rapid repayment method as you can save years off your mortgage.

debt recycling process
Debt Recycling with Investment Property Example

As you can clearly see the investment loans (in green) are kept completely separate from the non-deductible loans (Blue). However, all incomes flow into the non-deductible loan facility.

The faster you pay off your home loan, you can then access the new equity to purchase more property or investments and repeat the process. In effect, this is debt recycling.

With this strategy is that it’s important for there to be a net surplus of cash each month, this will ensure that your loan has a compounding reduction effect.

Rapid Mortgage Repayment Method

I wanted to show you a real example of the mortgage reduction method.

You can see the below that based on the rapid repayment method. The clients have a $300,000 mortgage that’s paid off in just under 16 1/2 years rather than the conventional 30-year P&I mortgage.

This example incorporates tax variations and also rental income associated with the property example above.

Again, it’s not magic. It is just using the systems and rules for your benefit rather than that of the banks.

rapid mortgage reduction method
Client Budget Information used to determine the timeframe reduction of the rapid repayment method
mortgage reduction
The rapid repayment method saves approximately 13 1/2 years on the mortgage & $92k interest

So as you can clearly see there’s a saving of $92,000 in interest and approximately 13.5 years.

What Are The Risks Of Debt Recycling

Debt Recycling isn’t without risk.

This is classified as a high-risk investment strategy because of 4 main reasons

1. Leverage Risk
leveraging risk

Basically with this strategy, you are using borrowed money to invest and utilise the cashflow of this to pay down non-deductible debt.

The problem you face is how highly you are leveraged, the higher your leverage. The greater the risk.

It is for this reason debt recycling is used for people with higher risk tolerance.

2. Putting Your Home At Risk
home at risk, debt recycling

This one is why many people don’t look at debt recycling as a strategy. They just can’t stomach putting their home in jeopardy. You have to be comfortable with debt.

Also, the dream for many is to own their family home. So borrowing additional against it (even if it’s for investment) just makes some people too uncomfortable with this as a sound investment strategy.

Another risk is that if you have an investment and the income return drops for some reason you are no longer getting the income that helps to pay your loans. If you can’t cover the repayments you can put your house in trouble if you can’t meet your loan responsibilities.

3. Interest Rate Risk
Interest rate increase risk

As everyone knows. Interest rates are fluid, that means they move up and down.

At the moment they are at historically low rates. However, it won’t always be the case. With any strategy, you need to ensure you can afford the repayments even if they increase.

We recommend you use a 3% buffer. If you can afford the repayments and strategy when you had 3% to your loans then you should easily be able to afford to take advantage of the debt recycling investment strategy.

Whilst interest rates have gone as high as 17%, over the course of the years they hover between the 5-7% as an average. The RBA sets cash rate targets and they are the ones who ultimately decide what that rate is.

4. Poor Investment Performance Risk
Debt Recycling Investment

Now, the whole goal is for your investment to perform.

However, there’s always a risk that it doesn’t. If you invest in property and do your research. It’s nearly guaranteed that you will make money over the long term.

However, if you need to sell or “cash in” on your investment, if you are doing so in a period of poor growth or performance you may lose money.

This is why debt recycling is labelled as a high-risk strategy. You must be comfortable with the up and downs of the market and be able to “hold” onto the asset to gain the advantage of growth over the long run.

Should You Consider A Debt Recycling Strategy

Absolutely yes.

As long as your risk tolerance can stand it.

I believe that this strategy is valid and very powerful when used correctly.

Another thing you should note is that you can use this strategy with just investment properties. You don’t need any non-deductible debt.

You can use this strategy as a mortgage reduction method against investment and then re-leverage that same property to gear yourself into a 2nd / 3rd / 4th / 5th + property. The strategy is valid regardless of the number of properties.

Many people use this strategy as part of their wealth creation goals.

You will find many planners advise shares, however, it doesn’t matter which class you invest (property/shares) what matters is that you ensure you invest in a quality product.

If you have bad debt – you should look at decreasing and removing this before starting this strategy.

As the better money management, you have in place before, the greater the net surplus will be each month and the faster you can pay off your home loan.

Now if you found this article informative pls share and post a comment.

If you have opposing views – great. Please share your comments with us, I’d love to discuss your ideas with you.

3 thoughts on “Good & Bad Debt: Debt Recycling Guide”

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Andrew Mitchell