Debt Recycling

By Slow Dad - November 20, 2016

Owner occupiers can turn bad debt into good debt by recycling their mortgage, extracting equity to purchase cash flow positive investments.

Turn bad debt into good debt

My last post discussed "rentvesting”: renting where you live, while owning cash flow positive investment properties that generate a passive income stream and benefit from capital growth.

There are two main approaches an owner occupier could adopt to pursue a similar strategy.

Debt Recycling can be a useful investment tool.
Debt Recycling can be a useful investment tool.

Rent out your own property, and rent someplace cheaper yourself

First they could investigate renting out the property they own, and opt to rent themselves. This decision requires some careful research, as a “dream house” seldom transitions into a well performing buy-to-let property.

This is because the location choices of owner occupiers are limited by what they can afford. Compromises are made, trading off property prices against commute times, school catchments, and so on.

Tenants have the luxury of choice, so there is less demand for compromise locations. This results in lower achievable rents in less desirable areas, which in turn reduces investment yield.

Renting out your home may be a viable strategy if the numbers make sense. Check with your lender first, you may need their “consent to let” the property if it is mortgaged.

Robert Kiyosaki’s Rich Dad, Poor Dad teaches that an owner occupied house is not an investment because it does not generate any income for the owner. Instead it is a drain on their finances, incurring maintenance and other property ownership costs.

Owner occupier homes can be a drain on their owner's finances.
Owner occupier homes can be a drain on their owner's finances.
Any debt used to purchase owner occupier property is classified as “bad debt”, similar in nature to credit cards and car loans. The owner has borrowed money to purchase something that will not generate them any income, and must now also pay interest on those borrowings.

Most owner occupiers will have some accumulated equity in their property. They will have paid a deposit when they purchased it. They will hopefully have paid down some of the loan principle via their regular mortgage payments. Maybe the value of the property has risen since they bought it.

Recycle your debt

The second approach involves “recycling” your debt.

You already own a property, over which you may already have an owner occupier mortgage. You can extract accumulated equity by redrawing on that mortgage, with which you cash flow positive investments.

The mortgage remains secured over your home.

You continue to make mortgage payments as before.

The income streams earned from your newly acquired investments contribute towards those mortgage payments. Providing the income generated is greater than your additional borrowing costs, you come out ahead.

The table below illustrates a real world example of debt recycling in action.

By investing a total of 55,000 I was able to purchase 3 properties over a 5 year period, with a combined value of just over 1,000,000. Two years later I sold one of the properties, using the proceeds to reduce the leverage of the remaining portfolio. By the end of that seven year period my 55,000 investment was worth over 390,000.

So what?

In many jurisdictions borrowing costs used for investment purchases are tax deductible, as they were incurred in pursuit of investment income. Your mileage may vary, ask your accountant.

Note this approach is not without risk, invest unwisely and you may jeopardise your home.

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