Reader Question: Debt Recycling

Over the weekend I received a question from one of my readers regarding ‘Debt Recycling’. Rather than replying to him privately, I thought that sharing my response could provide a valuable resource for others as well. If you’ve got a question for me, feel free to contact me. As always, please keep in mind that my ramblings are not tailored financial advice and you should always do your own research and consider what is right for you.

What is debt recycling?

Recycling isn’t just for cans and bottles. Photo Credit: kevin dooley cc

QI’m interested in your dilemma around investing vs debt reduction. Although it’s a ways off for us yet, one idea/strategy I have been exploring as a potentially key part of our financial plan is debt recycling.

As you may know, this basically involves splitting your existing home loan to create an investment loan, and using the equity you have built up in extra repayments or an offset account to buy investment assets. This keeps your level of debt the same; however the investment loan becomes tax deductible. You then use the income from investments (dividends, rental income etc) to reinvest into your home loan, then draw on this equity through your investment loan. Eventually, you will pay off the entirety of the “home” (non-deductible) part of your loan, then plow investment income into eliminating your investment debt.

To make this strategy successful, you would of course need to carefully check that your loan structure and approach met the requirements of the Australian Tax Office for allowing debt to be tax deductible.

Would be interested to know if this is a strategy that you have or would consider?

- Ben

A Hi Ben, thanks for your question.

I currently do not use a debt recycling strategy, however it can be a suitable investment strategy in certain circumstances. I have an interest-only mortgage with an offset account. Rather than paying down the mortgage, I pay into the offset. This strategy allows me to convert my home into an investment property in the future (I live around the corner from a university) and receive greater tax benefits than if I had paid the home off and borrowed to purchase a new primary home.

I’ve outlined the debt recycling strategy for you below, however I’d always recommend talking to your accountant or financial adviser before making any investment decisions. If you’d like more information, has asked 4 professionals about their opinions on debt recycling.

What is Debt Recycling?

Debt recycling is a long term investment strategy used in economies which do not offer a tax deduction for debt held over your primary home (e.g. Australia). The basic concept is  to convert non-deductible mortgage debt into deductible investment debt. Common investments include stocks or investment property. The debt recycling process can be broken into the following steps:

  1. Use available cash to pay down your mortgage (non-deductible debt) and increase your equity.
  2. On a regular basis, borrow an amount equal to the available equity and use these funds to purchase investments.
  3. Use investment earnings to further reduce your mortgage.
  4. Repeat
  5. Once your mortgage is repaid, start paying down the investment debt

While your overall level of debt remains constant, the percentage of your debt which relates to investments increases.

What are the advantages of debt recycling?

There are a number of advantages to debt recycling. By investing earlier, your investments have a longer timeframe in which to take advantage of compound growth. As the percentage of your debt which is tax deductible increases, you’ll be able to divert more of your cashflow to repaying debt and less to the taxman. Finally, it is possible to pay your mortgage off quicker if your investment return outshines your interest rate.

What are the disadvantages of debt recycling?

Your investment loans are secured by your home when using a debt recycling strategy. Because of this, you take the risk of losing your home should your investments perform poorly. Debt recycling requires healthy cashflow, you should receive sufficient to cover both mortgage and investment debt without relying on investment returns. Many banks will not lend over 80% of the property value for debt recycling purposes, so a significant amount of equity in your home is required.

Who may debt recycling be suitable for?

Debt recycling is only possible in economies where mortgage debt is not already tax deductible. Due to the volatile nature of the stock and property markets, debt recycling should only be considered if you have a long term (10+ years) investment horizon. High income earners will receive a greater benefit from tax deductions than those with a lower marginal tax bracket. Finally, you must have the discipline to use the extra cashflow generated to pay down debt as opposed to diverting it towards holidays, new cars or other lifestyle expenses.

What else should I consider before debt recycling?

It is worth considering your marginal tax rate when determining if debt recycling is right for you – the higher your tax rate, the more appealing debt recycling becomes. I’d recommend setting up a totally separate loan for investment purposes. You can still secure the loan against your home, but it will make it much easier to distinguish between investment and mortgage debt.

As with any debt, you should always ensure that the main source of income used to repay debt is protected using income protection insurance. This will ensure that debt repayments can continue even if you are unable to work due to medical issues.

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  1. Ben says:

    Thanks so much for responding to my question in such a comprehensive way Evan! Great to see that you take reader questions so seriously. This is a very useful summary on debt recycling, great work. I knew when I asked the question though that you would probably have an alternative strategy in place!

    The use of an offset account to allow you to convert your place of primary residence (PPOR) to an investment property (IP) in the future is a very clever way of getting the best of both worlds in home ownership and (deferred) property investment. As you point out, it also has added tax benefits, such as depreciation, which you can’t get from traded assets.

    I’ve also been considering whether the PPOR to IP option would suit us as a wealth creation strategy. I grew up in a family of renovators, so I can certainly appreciate the great potential that real estate offers to maximise profits. There is also a certain excitement and romance about real estate that can’t quite be replicated by a mutual fund or an ETF!

    Despite this, I have very much been sold on the simplicity, efficiency and power of index investing. The diversification, liquidity and ability to precisely control and your asset allocation are all pretty hard to beat. It may be dull, but it also takes a lot less time, effort and potential stress than being a landlord!

    We may yet go down the path of direct property investment as well (who knows what the future will bring!). At this stage though, I am planning to keep things clean and simple: Buy a house for the sole purpose of being a home (rather than trying to find a property that suits us AND will also make a good future IP); and pursue a passive income to support FI through an easy, low maintenance and (relatively) stress free portfolio of index investments. After all, isn’t a key aim of FI to reduce the time and effort you spend making money, and more on things you enjoy?

    Of course, we’re still very much in the “ideas” of our FI journey: all of our savings are currently being stashed away for a deposit on a first home (mostly in a First Home Saver Account ( you can’t beat a 20.5% PA return!) I’ll definitely be speaking with a financial planner, mortgage broker or account (or all of the above) before committing to any complex investment strategies.

    I’ll be very interested to see how you go with your place if you do decide to convert to an IP though (sounds like a great location!) Make sure you keep us posted.

  2. Wow this is really creative. But it also scares the jeepers out of me for the general public. While I would probably use a technique like this to buy shares of Index Funds which have the best 30 year long term probability, I can easily see a couple of wise guys trying to buy up the next hot stock only to have it all tumble down and then they lose their house.

    Coincidentally why not just use a buy and hold strategy with large cap investments? In the US you don’t pay capital gains tax until you sell the asset. So in theory if you pick several large cap value companies (i.e. the Dow Jones) you could not pay any taxes for several years.

    • Evan says:

      I would definitely recommend being sensible and only investing in index or bluechip stocks which don’t have a high volatility. As mentioned, this strategy is suited to long term investments as opposed to short term speculation. I wouldn’t recommend trying to actively outperform the market through trading, especially with borrowed funds.

      As far as using a buy and hold strategy, that is ideally what should be done with debt recycling. The strategy essentially aims to decrease the amount of debt you hold that is not tax deductible. You won’t pay any capital gains until stocks are sold, but in many countries the interest payable on investment loans is tax deductible as well – this is the main drawcard for debt recycling.

  3. Pauline says:

    Sounds like a great way to build wealth thanks to some cheap, tax deductible debt. Of course you need enough to cover the repayments if your investments go south but this is something I’ve been doing without putting a name on it and would recommend if you are not risk averse.

    • Ben says:

      Correct me if I’m wrong, but subject to their being no changes in interest rates (obviously not a realistic scenario), shouldn’t your repayments remain constant? Specifically, if you only draw on equity created by loan repayments (rather than property appreciation), and therefore your total loan amount remains constant, this shouldn’t change your interest repayments, right? Or have a missed some other risk factor?

      My current view is that, if you take a conservative approach to this strategy by excluding investment income and tax deductions from your affordability calculations, and build in the possibility of interest rate changes, potential investment underperformance should not impact on your bility to service the ongoing loan. Is this correct though?

  4. Evan says:

    Your minimum loan repayment should stay relatively constant if you only use equity from repayments as opposed to increasing property values. I say relatively constant, as it is likely that an investment loan will have a higher interest rate than the mortgage itself.

    I believe that Pauline may be referring to investing using not only equity from repayments but also from the loan appreciation. This would cause your minimum repayment to go up over time.

    If you are relying on investment returns to service the debt, you’re geared too high!

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