Recycling Debt

{Edit: I have split these posts from another thread - Distributions - Sim'}

Michael (and other who do this),

Can you please explain to me why you would choose to take the cash distribution from the fund to pay off your PPOR mortgage?

Assuming your mortgage interest rate is about 7%, as you're using after tax dollars you're effectively paying an interest rate of maybe 10% or 12% based on your gross income (depending on your tax bracket).

Why would you reduce your loan and effectively save yourself this amount of interest when the fund is returning 15% or 20%. Is it just for the SANF of reducing your non-deductible debt? From Sim's post above, aren't you missing out on growth by taking your distibutions as cash?

I have always re-invested my distributions, and will continue to do so until I actually need the cash flow to service my loans or lifestyle. I do have a PPOR mortgage and have always used the above reasoning to support this. Have I missed something subtle (or not so subtle)?

John.

 

JohnnyB,

Well, right now I'm at the absolute limit of my borrowing capacity based on LVR. So I need to create some equity if I'm to keep borrowing so I'm using the distributions to pay down the only bit of bad debt I have, that being my PPOR. I recycle the equity by borrowing against it to invest, but right now that's IPs so in a way I am re-investing my dividends, just not back in to the managed funds at the moment, I'm putting it as 20% down on IPs.

Specifically, I need to borrow another $700K odd to develop my site in Mona Vale so am actively paying down my bad debt as quickly as possible to improve my borrowing capacity. When I no longer need the equity then I'll probably re-invest into the fund so I can improve my cash flow, but right now equity is more important to me (and more tax effective).

Cheers,
Michael.

 

Thanks Michael. Makes sense to me now. I've still got a bit of LVR to play with so it wouldn't have occured to me to do what you're doing (although I'll probably need to do it one day too).

John.

 

John

I don't have any bad debt but I do have the holding costs of 3 negatively properties, so the cash basically pays the holding costs and I use the leftovers for lifestyle

Gazza

 

John,

Here is a rundown of the basic principles of debt recycling:

- PPOR debt $200,000
- Navra investment $300,000
- Navra returns 10% p.a. = $30,000 income
- Use that $30,000 to pay down principal on PPOR
- After twelve months release that $30,000 from PPOR to invest into Navra
- Now have $330,000 in Navra and $170,000 PPOR debt
- Navra returns $33,000 income

and so on and so forth. If you have margin, then effectively double those returns (although losses would also be doubled in worst case scenario).

As a rule, we use a return of 10% in structure and planning. Anything above that is a bonus.

Mark

 

Thanks for the example Mark. If I'm reading it correctly, by doing as you suggest you are converting your non-deductible PPOR debt into a deductible LOC (ie you set up a $30K LOC to release the equity you have paid off your PPOR). Is that right?

Isn't there some inefficiency though:
1. You've taken out $30K from the fund which sits in your mortgage for a year, so you're missing out on this being invested in the fund for that year. I guess as long as this "opportunity cost" is outweighted by the effect of changing the non-deductible to deductible debt (depends on your marginal tax rate??) then it's better overall. I'm not convinced yet. I'll need to get a spreadsheet going for this one I think

2. When you release the equity from your property, you will only be able to get back 80% of what you put in. Or are you assuming the value of the property has also increased in that year, so you can get back the full $30K (if not more)?

John.

 

Don't have a problem with this gazza - for me that's exactly what an income fund is there for

John.

 

Yes that's correct.

It always depends on the person. Some people like the idea of 'having your cake and eating it too', that is, being able to pay down some of their PPOR debt and exchanging that non-deductible debt for deductible debt.

I never make assumptions. When you assume, you make an ass out of u and me. My understanding is that you would be able to borrow back the full $30,000 as long as the LVR on the property as a whole doesn't go over 80%. Happy to be corrected of course.

Mark

 

"When you assume, you make an ass out of u and me"

Mark,
Hahahahahaaaaaaaaaaa....
Good one !!!!!!

 

Hi this is just my first post sorry for the ignorance.
form the example given you
have a 200k loan ppor
300k navra


Income from navra =30k

so ppor =170K

when you redraw 30K doesnt the ppor stay go back to 200k?
so that you can put more into navra at 330k??

 

Hi Blackjack

Without wanting to pre-empt Mark's response, that is correct. You would have reborrowed the $30k you've just paid down.

BUT the interest on that $30k is now tax deductible because it is being used for an income earning purpose, namely to buy units in a managed fund.

Cheers
N.

 

Thanks for that.
Hmm . so this example is more about shifting your debt. from non deduct to deductable.

 

I can see the light !!!!!!

Man, i have been grappling with the maxed out DSR LVR beast and this discussion has been like making the last turn of a rubicks cube, I think I've got all 6 sides worked out !!!

I work with numbers all day long, I work with property all day long, other people's property, not resi (btw I'm not an RE or PM).

And yet this discussion has taught me something very valuable. While I'm not the sharpest knife in the drawer I don't regard myself as the dullest. My point is you will never know everything, so read, listen, discuss and leave your pre-conceptions at the door.

You may be surprised at what you can learn !

 

Further to the above point regarding the opportunity cost of reinvesting distributions vs using distributions to pay down non deductible debt.

My take is this : The non deductible interest saving on my mortgage is a guaranteed return at approx double the interest rate on my mortgage (obviously depends upon tax brackets). While I may miss out on the compounding effect of reinvesting the distributions, because I choose to use the increased equity in my ppor to invest in property, by virtue of the leveraging advantages of property I believe that ultimately the distributions will achieve a greater return.

I have not run a spreadsheet to prove this, its just based on concepts.

This will suit my individual circumstances, it may not suit yours.

 

Mark, out of interest can I ask what the relevence is of the "after 12 months" bit on the sentence "- After twelve months release that $30,000 from PPOR to invest into Navra". As in why I'd wait 12 months to put that $30,000 in NI and miss a year's worth of returns ? I know there is an answer, I just don't know what it is ! ;-)
Cheers
Carl

 

Hi, TryHard,
I believe Mark is using a simplified example to explain the principles of paying off bad debt and then using the increased equity created for investment purposes. The 12 months is the time it takes to receive the $30000 from your investment rather than a 12 month delay after receiving the $30000.

It would be a very poor Tax stragegy mix the purpose of a loan for private and investment purposes. So rather rather imediately redrawing quarterly distributions from your PPOR, you would more likely redraw the increased equity via another investment loan secured by your home by annual topup applications on the investment loan which also had the PPOR loan credit limit set down by a corresponding amount.

Cheers

 

Thanks Tasmo

I think I (nearly) get it. I'm familiar with the need to make sure the 'bad' debt and deductible debt don't get intertwined. But if I say tomorrow pay down the PPOR loan by $30,000, and ask for a corresponding extra $30K in my LOC, that wouldn't be muddying the water, would it ? As in I then have $30K clean fresh shiny paper-trail dollars to put in NI.

So what you're saying is Mark's example really means that the $30K will be paid off the PPOR in the 4 quarters as the distributions come in, and at the end of the full year's worth of paying off that amount from the PPOR, you'd be in a position to ask for that $30K back (immediately) into a separate LOC for investment purposes, and then free to use that dough immediately too ?

Sorry for sounding thick. Its 'cos I am ;-)