Debt recycling:
Debt recycling is generally one of the strategy for the people who wants to build wealth from debt effectively.
When planned and executed properly debt recycling can work in favour but its definitely not risk free thus it will not sure everyone. Lets understand this in detail with a case study.
Case Study :
Tom is an illusionary person for this case study purpose with Annual income of $100, 000. Depending upon the country he is leaving he will have to pay tax on that income to the government. For this case study purposes lets say the tax rate is 35%.
He bought a home with loan ( mortgage ) of $400, 000 5 years ago. He is been paying around $2000 monthly repayments at an interest rate of 4% over 30 years. He was also making significant lump sums payments during this period to reduce the over all debt and after the end of the 5 year period his remaining loan principal = $250, 000.
Tom has relativity stable job and mostly he manages his expenses pretty well and he decided to invest in shares with the view of achieving financial freedom in life.
As like most countries, Tom lives in a country which encourages investments with the incentives.
One of which is : Tax deductible interest that is paid towards acquiring investments assets. That means if Tom borrows $10,000 from a bank to invest in shares any interest that he is going to pay on this $10,000 is tax deductible.
Tom has below options with money that he will have after paying all the bills ( and lifestyle expenses) at the end of the month.
1. He could make additional payments into the mortgage
2. He could buy shares with that money to achieve his goal
3. And here comes the third option .. Debt recycling ..
First 2 options are fairly straight forward and in fact even the third one as a concept and theory is not that complex. so what is that ?
Debt recycling
He pays additional savings into the mortgage and borrows money from the bank to invest.
Ohh well , how is that helpful ? Here is how ..
Tom has essentially reduced his non deductible debt by paying down his mortgage and borrowed money has deductible debt to invest. Numbers ..
Over the period , he could repeat this process to significantly built his asset column and also reinvest the profits ( after tax ) back into assets.
So why not everyone is doing it ?
1. The assets that acquired with the borrowed money has to produce significant returns/profits to offset the interest that he is going to pay on the borrowed money.
2. Generally money borrowed for investments comes with higher interest rate and it is often require good serviceability.
3. Interest rate are not often fixed. if you choose variable interest rate, it could go up and thus the need for investments to produce more profits.
Thank you so much for reading all the way through !! . Again this blog post is to explain my understanding of debt recycling and I am not an accountant and financial advisor. :).
