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Debt Recycling

Debt Recycling

Robert Kiyosaki (author of Rich Dad, Poor Dad) espouses a school of thought that owner occupied property should not be considered an asset because it fails to generate an income for the owner.

Personally I’m not convinced by this argument.

I am a big believer in creating a collection of diversified cash flow positive investments, financial freedom being achieved when those investments reliably cover the owner’s living costs. So from a simple cash flow perspective Kiyosaki makes sense.

However those living costs are likely to be significant lower if, instead of having to pay market rents every month, the owner lives in a property they own outright.

Ultimately this becomes a quantifiable opportunity cost argument, with the correct buy versus rent outcome for each individual being determined by the numbers.

What if you are already an owner occupier?

There are a few options available to an existing owner occupier who wishes to redeploy accumulated equity in their home towards a higher performing cash flow positive investment.

The most obvious option is selling. However given the huge transaction costs involved this is often a suboptimal choice.

Releasing trapped equity

Owner occupiers can turn “bad” debt into good debt by recycling their mortgage. Trapped equity can be more productively redeployed to purchase cash flow positive investments.

In a recent post I discussed the concept of “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 existing owner occupier could adopt to pursue a similar strategy.

Cashflow play: Rent out, then rent cheaper

As a pure cashflow play, an owner occupier could investigate letting out the property they own then renting somewhere cheaper for themselves.

This decision requires some careful research, as a “dream house” seldom transitions well into a cash flow positive investment property.

The property choices of owner occupiers are often constrained by what they can initially afford. Compromises are made, trading off property prices against desirable locations, commuting times, school catchments, and so on.

Tenants enjoy the luxury of choice. The more compromised the location, the lower the tenant demand will be. This results in lower achievable rents in less desirable areas, putting a significant dent in the potential 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.

This option only makes sense where:

(Tenant's Rent - Owner's Rent) > Property Financing Costs

Equity release: debt recycling

Releasing trapped equity involves borrowing against a property you already own. This may involved refinancing or redrawing on your existing mortgage.

The extracted equity is deployed towards acquiring cash flow positive investments.

The mortgage remains secured over your home, and you must continue to make mortgage payments as before.

The income streams earned from your newly acquired investments contribute towards those mortgage payments.

This option makes sense where:

Investment cash flow > Additional Property Financing Costs

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

Debt Recycling

Debt Recycling in action.

By investing a total of $55,097.13 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.

I was able to recover my $55,000 of cash contributions, and still be left with equity worth over $473,000.

At that point I could have sold a second property and used to proceeds to fully pay off the mortgage on the remaining property.

This could have provided me with rent/mortgage free accommodation for the rest of my life, or alternatively contributed $26,000 in annual free cash flow towards covering my own lifestyle costs. As they say in Finland, that is better than a hat full of rabbits!

Other considerations

In some jurisdictions the borrowing costs associated with investment purchases may be tax deductible.

The general principle is guided by what the purchase was for, rather than what it was secured against. Do your own homework, and if in doubt consult a qualified accountant.

Note debt recycling is not without risk, invest unwisely and you may jeopardise your home.

Next Steps

  • Run the numbers to work out if renting out your home is financially beneficial.
  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.

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