Tax Tip 2: What is Debt Recycling?
‘Retirement’ can arrive sooner if you can pay off non-deductible debt faster.
Interest on a loan used to purchase the main residence is not deductible – some call this ‘bad debt’. While interest on loans used to purchase investment properties (shares, business etc. too) is deductible – so called ‘good debt’.
So wouldn’t it be good if you could change bad debt into good debt so you increase deductions to save tax and pay off loans faster?
Well, you can!!
As an example, most people would be paying PI on their home loan. The balance would be slowly decreasing. Some would be paying extra on the loan to pay it down faster. If you could reborrow this extra money paying off the loan and then invest it you would be charged around 4% pa in interest. This interest would then be deductible against the income from the investment. If the investment earns more than 4% pa then you would be in front and the extra money received could then be used to pay down the bad debt even faster.
Further reduction of bad debt would potentially mean more funds are available to be borrowed to invest. This in turn would potentially lead to more income to pay off the bad debt which could then be turned into good debt by borrowing again to invest.
If all goes well this could enable the bad debt to be paid off much quicker as the compounding takes effect.
This could be done with property, but most property would end up negative cash flow. But it could also be done with negative cash flow property and just hanging on for a few years and then selling and using the proceeds to pay down the bad debt and then reborrowing.
You could speak to a licenced financial planner about using shares to do this. Shares are much easier to buy and sell and the costs in and out are very low.
Carefully planned, debt recycling can get you where you want to go sooner.
2018 update – these days owner occupier loans are at a cheaper interest rate than investment loans. Properly structured, debt recycling can allow owner occupied interest rates for investment loans, helping you to recycle a little bit faster still.