You may have heard people discussing “good debt” and “bad debt.” In general, good debt is something that will increase in value over time. Bad debt, on the other hand, is something that will lose value over time.
Converting bad debt into good debt, commonly known as ‘debt recycling’, is one strategy that can help you reduce your overall debt burden and improve your financial situation.
If this sounds like something that could help you achieve your financial goals, this article will explain everything you need to know about debt recycling in Australia.
What is Debt Recycling?
Debt recycling is a way to pay off your home loan by leveraging the equity in your home to invest in income-producing assets, for example, investment property, ETFs or shares.
The underlying idea is that you use your investment income to make your loan repayments. This way, you can pay off your loan faster than if you were making regular monthly repayments.
With debt recycling, you can simultaneously create wealth as your new investments grow in value, even as you pay off your mortgage. In addition, as you increase the equity in your home, you can borrow more money against your property and reinvest dividends.
In the process, you are also shifting your non-tax deductible home loan debt to a tax-deductible debt of a separate investment loan.
Can You Debt Recycle in Australia?
Yes, you can take the debt cycling route in Australia.
Debt recycling works to help you begin your wealth creation process immediately. The strategy is already helping many Australian home buyers to make their loan repayments sooner than they thought was possible.
In sum, debt recycling facilitates additional tax savings while investing. It shouldn’t be confused with any tax avoidance scheme where you’re collecting fake tax deductions.
“If you’re concerned about issues with ATO, you could always read the discussions on the ATO Community platform. Alternatively, you can consult your financial advisor to determine if the debt recycling strategy suits your circumstances,” adds Graeme John, Head of Growth at Joust.
Who Can Debt Recycle?
Notably, there’s no specific loan for debt recycling. It can be your standard home loan.
Many lenders will also allow you a loan split into smaller portions. It’s nearly similar to the split between fixed and variable interest rate loans.
Also, having an offset account attached to your loan split is a good idea. Keep the loan split and offset funds separate from your main offset and loan account. This will help you differentiate and keep track of your personal and investment funds.
Debt Recycling for Principal-and-interest and Interest-only Loans
You can debt recycle using both principal-and-interest and interest-only loans.
In all probability, like most home buyers, your primary home loan is probably a principal-and-interest loan.
Interest-only loans are more effective when considering debt recycling since repayments are typically lower. In addition, this allows you to divert surplus cash flow towards paying down your non-deductible loan even quicker.
Nonetheless, your lender may want to re-assess your capacity for borrowing money when you switch a portion of your loan to interest-only.
Some home loan borrowers opt for a Line of Credit home loan. However, since the interest repayments are high, most avoid this pathway.
How to Debt Recycle?
Here’s a breakdown of how debt recycling works to help you understand how you can use it to your advantage:
1. Leverage your home equity: For starters, you’ll need to accumulate significant property equity. Where your LVR is more than 80%, you may need to pay costly Lenders Mortgage Insurance (LMI) before you are allowed to access your equity.
2. Borrow funds: You now borrow money against your home. It is then invested in an income-producing asset, such as shares or investment properties that you can rent out to produce income.
3. Wait for the extra money: If done right, your investment asset will start to bring in income. This is used to pay off your home loan through extra loan repayments. As repayments increase, so will your home equity. You will now be able to borrow more money for investing.
4. The cycle repeats: As the cycle repeats, you’ll end up with only the tax-deductible investment loan to pay off. On the sidelines, you may also be able to generate passive income while you ultimately pay off your debts.
Debt Recycling Strategies
You can implement debt recycling in either of the following ways:
In this method, you’ll need to leverage some of your home equity to create a separate loan split. Next, you put this equity into a new offset account attached to your new loan split.
Instead of investing, you use your monthly savings to pay your primary home loan. You then take a similar amount from the new offset account attached to your new loan and put it in your brokerage account to purchase income-producing shares.
Since you have it for investing, the interest payments on your new loan are tax deductible. The advantage of this method is that it allows investing the minimum monthly amount in shares at regular intervals than investing in big chunks.
Where you do not have enough equity in your property, you could set up a loan split, for example, $25k with your current loan and pay it down with your monthly savings.
Once the portion is paid, you take out the monthly amount you want to invest. Then you create another split, and the cycle continues.
As per this method, you’ll repay your mortgage lump sum, re-borrow, and invest those funds. As the cycle continues, you save another chunk and continue the process. This debt recycling strategy is more popular as most lenders have a minimum loan split that you can create.
How Much Can You Save with Debt Recycling?
Debt recycling can help to reduce the interest you pay on your loan and make you mortgage-free faster. The following example will help you understand how to make the most of debt recycling work:
Debt Recycling Example 1
Sally owns a home worth $600k with a $350k loan and $150k in her offset account.
Having opted for debt recycling, she splits her home loan into two loans, i.e., $200k and $150k, respectively.
She now pays off her $150k loan with her offset money. She then takes a similar amount from the new offset account and puts it in her brokerage account to purchase shares.
Since she has invested in an income-producing asset, the interest on Sally’s $150k loan is now tax deductible.
Debt Recycling Example 2
Consider Alan, whose home is worth $500,000 and whose remaining mortgage is $250,000.
Alan can borrow $250,000 of equity. However, most lenders will only lend Alan 80% of his property value ($400,000) minus his mortgage ($250,000). Thus, Alan’s usable equity is $150,000.
Next, Alan draws out $100,000 of his usable equity as a tax-deductible investment loan and moves it into income-earning shares.
The value of his investments increased by $7,000 and yielded an income of $5,000 over the following year.
Alan uses his investment income ($5,000) to pay his mortgage in addition to his regular principal repayments ($8,000). Overall, he managed to lower his mortgage by $13,000 in one year while building the equity in his home.
That done, Alan takes out the same amount, i.e., $13,000, reinvests it and repeats the cycle until his entire mortgage is paid.
Benefits of Debt Recycling
Debt recycling enables you to convert the non-deductible debt, such as your home loan repayments on your owner-occupier home, into debt with tax deductions. For example, the interest on your investment loan. The bigger your marginal tax rate, the more profitable it becomes.
Diverse Income Portfolio
Debt recycling can give you access to various assets from the beginning, which you may not have been able to afford without this strategy. With debt recycling, you enjoy both compounding returns and a diverse asset base that insulates you from any market downturns in future. It also helps generate a passive income through investments.
Faster Wealth Generation
With debt recycling, you can start wealth creation more quickly. It helps sustain the long-term growth of your investments, providing long-term investment funds and income. Even better, you can easily access your liquid assets wherever necessary.
Attain Life Goals Faster
If you’re among the growing tribe of Aussies who want to retire early, you’ll have realised that the growth potential of investments has reduced between paying your home and retirement. Debt recycling helps you kickstart wealth creation immediately. In addition, using debt recycling, you can simultaneously pay off your home loan, enabling you to reach your lifestyle goals quicker.
Debt Recycling Risks
Borrowing money for investing in rising markets can lead to significant gains. The reverse holds for falling markets. Your losses increase significantly as you still have to pay interest and repay your loan.
Rising Interest Rates
In a scenario of rising interest rates (as seen in recent times), repayments will increase if you’re on a variable interest rate loan. This pressure on your cash flow will further increase if income from your investment portfolio is lower than your targets. Also, interest rates associated with debt recycling tend to be higher than the standard variable mortgage rate.
Drop in Asset Value
If the value of the asset purchased with your borrowed funds drops, you’ll have an investment loan to deal with, and low or no returns to help you repay. Furthermore, you may still be in debt after selling off the asset.
Taking on More Debt
Shouldering the responsibility of loan repayments can overwhelm some. In addition, the possibility of defaulting leaves you open to losing your present home. In addition, if your job is not very secure, debt recycling may not be suitable for you. Generally speaking, debt recycling is more suited for anyone with an investment timeframe of seven years and above.
If you’re considering this option, you should check if your insurance cover takes care of the extra loan if something happens to you.
Though the loan interest paid on your investment loan is usually tax-deductible, there are tax implications on the capital gains made from your investments.
You can claim interest incurred only if your debt has been used to produce income. So, for example, you will have to pay capital gains tax if you sell your shares at a profit.
This is because the tax office considers any profits from the sale of shares as part of your income. As a result, profits will be taxed at your marginal tax rate after including any other income you earn.
How Much Can You Save with Debt Recycling?
Home buyers are attracted to the additional savings and wealth generation that debt recycling offers. The following example shows the potential savings you could make by recycling your debt:
Say you have a $350k home loan. The interest rate is 3%, and you have $150k in cash:
- Scenario 1 - You do not adopt debt recycling: In this case, you would directly invest your $150k. From your income of $5k, you would pay, for example, 50% tax. This would leave you with $2.5k.
- Scenario 2 - You adopt debt recycling: In this case, you would pay off your non-tax deductible debt of $150k, redraw the exact amount and invest it while receiving your $5k income. Now you can claim $4.5k of interest as a tax deduction (interest on $150k). This means you have only to pay tax on $500 of investment income, which is $250.
Comparing both scenarios, you’ll find that debt recycling helped you $2,250 in tax, given the same financial resources.
Is Debt Recycling Worth it?
Debt recycling can be an effective strategy to accelerate your financial goals. These checkpoints can help you make sure that debt recycling is the right fit for you:
- Your circumstances: If you have home ownership or significant equity in your property and have some funds that you could invest, then debt recycling may be worth considering.
- Investment experience: If you’re not an experienced investor and/or are not in a position to take on high risk, debt recycling may not suit you. However, suppose you are still interested in this option. In that case, it’s best to seek professional advice from a financial advisor who will be able to help with investment strategy and tax advice.
- Long-term investment: With debt recycling, any capital gains you make on your investment get magnified. Likewise, your capital losses, if any, will also be magnified. Therefore, debt recycling works best when considered as a long-term strategy, and you have a separate income source other than your investments as a buffer. Moreover, risks increase via exposure to market volatility. Therefore a balanced investment portfolio can help support this strategy.
Debt Recycling vs Offset
If you feel debt recycling may not suit your circumstances, you could consider the offset option.
Per this strategy, you must link your home loan to an offset transaction account. Then, the balance in your account or a proportion of the balance will be ‘offset’ daily against the balance home loan.
This way, you save on interest repayments as it’s charged on the difference between your total loan balance and your offset amount. In addition, it also enables you to have extra funds readily available for emergency use.
Mostly offset accounts are linked to variable rate loans, but some lenders also offer fixed home loans.
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