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The Top 10 Risks of Debt Recycling

What is debt recycling?

Quite often the first time you hear about debt recycling will be from a financial planner or a friend that has been to see one. The basic idea behind debt recycling is you should reduce your non tax deductible interest on a debt and replace it with tax deductible interest on a another debt. The purpose is to increase the tax efficiency of the borrowing which will contribute to the repaying of the non tax deductible interest debt sooner. In some countries the interest on a home loan mortgage is deductible. Some of the countries are The Netherlands, Sweden, Switzerland and the United States. You should not undertake this strategy without getting written financial advice, preferably, from a Certified Financial Planner who is also authorized to give tax advice. This article should not be viewed as advice, but from an accounting risk management approach warning of some of the dangers of debt recycling.

The process of debt recycling

Debt recycling is a strategy used to help a person pay off their home mortgage or other loan with non tax deductible interest earlier than the normal term while at the same time growing an investment portfolio.

Normally this means taking a separate investment loan against the equity in their homes initially and at the end of each year increasing the loan and investing that money in a portfolio of investments. The purpose of debt recycling then is to increase your wealth by enabling you to invest your money while still paying off your mortgage sooner. Therefore, debt recycling can be summed up in four steps:

1. You take out an investment loan against your home equity separate from your home mortgage or other loan for consumption purposes.

2. Borrow up to no more than 80 percent (preferably 50 percent) of your home equity each year and invest the borrowed monies into investments, such as shares and stocks. The income from the investments is used to prepay the non investment loan that bears the non tax deductible interest.

3. This means that the interest tax deduction in most jurisdictions is allowable as the related investments produce income that is used repay your outstanding mortgage loan or other consumption loans that do not have interest as a tax deductible expense.

4. You continue the process each year until you have your home loan or other non investment loan paid off in full. At that time, you should have surplus monies after you debts are repaid.

The Top 10 risks of debt recycling.

The strategy of debt recycling is an aggressive financial planning strategy and for most people it will not match their risk profile, especially if they are a family with children at home and are exposed to lifecycle risks associated with raising children.

1. That you do it without getting paid for advice from a Certified Financial Planner who is also authorized to give tax advice

2. The real risk involves the investments falling in value and you end up losing, which of course is one reason why your investment portfolio should always be constructed by a Certified Financial Planner.

3. That you undertake the project with a time horizon of less than five years and you may end up losing more than gaining during an economic cycle.

4. That the terms and conditions of your loans do not allow you to prepay and redraw at your discretion and you do not have an interest only repayment basis as a loan option.

5. That the valuation of your bank’s security property falls and that they require further security for the loans during a cyclical downturn. This risk can be reduced by lowering your initial loan security ratio.

6. That the interest rates on your loans increase dramatically over the periods of your loans and erode the profitability of the strategy.

7. That the taxation laws change during the period of the project.

8. The employment basis of you and your partner changes during the project and the tax strategy diminishes or evaporates. This risk also relates to the ownership of the loans and investments.

9. The assumptions that are made about the investments are poorly researched and not valid.

10. That your Certified Financial Planner does not arrange adequate insurance for income protection, trauma or death and disability.

This article is written from an accounting risk management perspective, but financial planning can help you not only with debt recycling but also with your budgeting so that you have a clearer understanding of your overall financial goals, not just debt recycling. Therefore, having a Certified Financial Planner as an ongoing professional paid advisor whenever you need to make major financial plans makes good sense.

Look at other alternatives

Make sure that you look at other alternatives to debt recycling to growing your wealth. For many people this is a less risky approach and from a Lifestyle Planning perspective a better approach especially if you are raising a family when you are exposed to lifecycle risks associated with your children.

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