How to turn bad debt into good

“How can I recycle debt?” you may ask, and what is the difference between “bad debt” and “good debt”? Good question. With 15 million credit cards in circulation in Australia as of 2012, consumers are all too familiar with debt.

Basically, debt that buys assets or produces income is considered “good debt,” while debt that is created by buying life’s niceties or your primary residence is considered “bad debt,” since it does not normally bring in any income.

As such, many people have a fear of debt and aim to pay their mortgages off as soon as possible, although this may not necessarily be the most effective way to use debt. However, debt that creates appreciating assets, or debts that reduce the tax you are paying or that effectively earn income, are commonly referred to as “good debt.”

When consumer confidence diminished it resulted in less borrowing by consumers, leading to recent interest rate cuts – making it an ideal time not only to consolidate debt, pool various loans and credit cards into one loan or mortgage, but also to look for ways of making debt work for you.

This is where debt recycling comes in. Let me provide an illustration:

Let’s say you own a home in Sydney on which you owe a $400,000 mortgage with an offset account attached to it.

Using the equity in your home, you borrow additional money against it for a deposit to buy an investment property. You do this with an interest-only loan.

Each month, all the income from the investment property goes into the original offset account attached to the home loan with any tax refunds generated by the investment costs also going into this account.

The bulk of your wages can also be put to work in this account using your credit card for living expenses, and clearing it at the end of each month. Plus, you can seek a tax variation so you pay less income tax every month, rather than annually, leaving even more cash flow to go into this account.

Money comes out of the offset account to meet the interest payments and other expenses related to the new investment property, but if you have bought well and done your sums, there should be enough left over for the offset balance to gradually build up, effectively reducing the interest you pay and the capital owing on your primary asset being your owner-occupied home.

Once that’s paid off, there's only tax-deductible “good debt”, and the cashflow that's freed up can be applied to either reducing that debt further or for another investment, be it real estate or other.

In preceding illustration, we can start investing earlier than if we waited until the mortgage on our home was paid off and can effectively “recycle” non-productive “bad” debt into tax-reducing and asset creating “good” debt.

However, it can be complex depending on your individual circumstances and finances. I urge you to work closely with an expert, so you don’t end up with more of the “bad” and none of the “good.”