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.
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?
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, News.com.au 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:
- Use available cash to pay down your mortgage (non-deductible debt) and increase your equity.
- On a regular basis, borrow an amount equal to the available equity and use these funds to purchase investments.
- Use investment earnings to further reduce your mortgage.
- 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.