In a recent article published in Alan Kohler's Eureka Report, financial education consultant Scott Francis looks at the use of debt recycling. This is the practice of taking on some investment debt while at the same time repaying your mortgage, a non-tax-deductible debt.
Scott points out that there are clear risks with the strategy. Borrowing to invest is intentionally risky: you are increasing the volatility of your situation in the expectation of providing a long-term benefit to your position.
For example, if you had started this strategy two years ago, you would be significantly underwater and probably preferred to have just paid off your mortgage instead. But recognise that the long-term average return of the sharemarket over the past 30 years is 12.6%, which can produce sizeable benefits.
The benefits of the strategy are three-fold:
- You are reducing your non-tax-deductible debt.
- You are building a passive income stream from the shares.
- The increasing stream of dividends from the share investments helps pay the mortgage off faster.
There are a lot of problems with the most frequently used approach to borrowing to invest, whereby a lump sum is borrowed and invested using a margin loan.
Three of these problems include:
- Margin loans are often very expensive.
- There is the risk of a margin call when the value of a portfolio falls sharply, forcing you to sell at a time when markets have fallen.
- Investing a big lump sum at one time means that you are very exposed if the market drops suddenly.
A debt recycling strategy provides a solution to all of these problems. Borrowing against your house is usually cheaper that a margin loan, without the concern of a margin call.
Because you are investing on a regular basis (each year, for example), if markets do fall you have the advantage of making further contributions over time and buying more assets at lower prices.
A debt recycling strategy is certainly more suited to those people comfortable with investment risk. At the end of the day it won't work unless there is a reasonable return on the investment involved.
For those willing to take that risk, it provides a way to build an investment portfolio over time, reduce your non-tax-deductible debt and start to build a passive income stream from your investments.
To take a look at the full article please click on the following link - Recycle your debt.