For those investors who are open to using debt in their situation to build wealth the implementation of a debt recycling strategy may be of value.
A Debt recycling strategy is where home owners with a mortgage transfer debt from the non tax deductible home loan to a tax deductible investment loan through the course of paying down the home loan.
The benefit of the strategy is that interest payments on the investment loan are able to be deducted from investment income when it comes to income tax time each year. In essence, by doing this you are seeking the assistance of the federal government to help build your pool of financial assets.
Is it a good idea for everyone?
Definitely not. The first key step is to undertake a stress test of your current debt position. In its simplest form this means looking at the impact on your your cash flow should interest rates rise. Will you still be able to make loan repayments if interest rates rise to certain levels. This is very pertinent at the moment as more and more commentary suggests that the Reserve Bank will lift interest rates by 2% over the course of the next 12 to 18 months. i actually think you should stress test your situation in case rates rise by 3 or 4% to be even more comfortable that you are not holding too much debt. See the problem becomes that should interest rates rise to levels where you are unable to make loan repayments you will most likely be forced to sell. If interest rates have risen by significant amounts there is a good chance that this will be exactly the time you do not want to sell.
(To add another layer of complexity, it is also worth contemplating what would be the situation if you lost income for whatever reason for a period of time - cut back in hours, ill health, retrenchment - how long could you continue to make repayments on a particular loan value - but lets leave this for another blog.)
Once you have gone through this exercise and decided that you could afford to maintain $X amount of debt even if interest rates rose to a level well above say 10%, you could possibly be looking at a strategy of once paying down so that you home loan is now less than $X every extra dollar you pay off the loan is used to increase an investment loan which is used to invest in other growth assets like shares and listed property.
Is it a good time to invest in shares and listed property?
The next question that should be asked is whether now is a good time to loan money to invest in shares. With interest rates at between 5 & 6% the odds are in your favour because over the long term shares have provided a return of between 6 & 7% above inflation. So if the Reserve Bank is targetting inflation of 2 to 3% this suggests that shares should provide a return of 8 to 10% over the long term. Wo this comparison looks pretty positive. However as interest rates start to rise in the economy the differential between the cost of the loan and the likely return from the investments starts to narrow and the likelihood of success also narrows.
Now in the interests of providing a full and frank viewpoint, some will suggest that maybe the risk premium for investing in shares is higher than historical levels. This is saying that the current risks involved with investing in shares, which we have been all clearly reminded off through 2008 and early 2009, may be more than usual and therefore investors expect a higher return than the 6 or 7% premium above inflation. The period March to September 2009 would suggest this has been the case but we can not be certain that such conditions will continue going forward.
On the opposing side are those that suggest that the world economy is in the middle of an L or W shaped cycle where there is at best a long period of little growth ahead of us or at worst we are in a bear market rally with bad conditions still to be faced.
What do I think?
I claim no ability to predict the future so for me it comes down to this question -
Do you need to take on extra risks to reach your financial goals or are there other strategies at your disposal through cost reductions and the like?
If you don't need to use debt than don't. If you do, then seriously weigh up the possible outcomes and limit the use of debt to the minimum.
As always the decision comes down to each person's individual circumstances. If you are thinking of using this strategy it would be very wise to first consult a financial adviser for guidance.
Following up from my previous blog - MLC have a useful case study on their website which explains the strategy of debt recycling. It is worth a look for those who might be contemplating this approach - MLC Debt Recycling page.