Phase transitions in debt recycling

Abstract

Debt recycling is an aggressive equity extraction strategy that potentially permits faster repayment of a mortgage. While equity progressively builds up as the mortgage is repaid monthly, mortgage holders may obtain another loan they could use to invest on a risky asset. The wealth produced by a successful investment is then used to repay the mortgage faster. The strategy is riskier than a standard mortgage-repayment plan since fluctuations in the house market and investment's volatility may also lead to a fast default, as both the mortgage and the liquidity loan are secured against the same good. The general conditions of the mortgage holder and the outside market under which debt recycling may be recommended or discouraged have not been fully investigated. In this paper, in order to evaluate the effectiveness of traditional monthly mortgage repayment versus debt recycling strategies, we build a dynamical model of debt recycling and study the time evolution of equity and mortgage balance as a function of loan-to-value ratio, house market performance, and return of the risky investment. We find that the model has a rich behavior as a function of its main parameters, showing strongly and weakly successful phases – where the mortgage is eventually repaid faster and slower than the standard monthly repayment strategy, respectively – a default phase where the equity locked in the house vanishes before the mortgage is repaid, signaling a failure of the debt recycling strategy, and a permanent re-mortgaging phase – where further investment funds from the lender are continuously secured, but the mortgage is never fully repaid. The strategy's effectiveness is found to be highly sensitive to the initial mortgage-to-equity ratio, the monthly amount of scheduled repayments, and the economic parameters at the outset. The analytical results are corroborated with numerical simulations with excellent agreement.