Debt recycling is a strategy that wealthy people use to pay off their mortgages faster and invest at the same time. In this article, I’ll explain the process of debt recycling and share my thoughts on it. I’m going to cover how it works in theory, how it actually works in practice, and my honest opinion on whether it’s worth it.
The theory of debt recycling is great, but it can be a bit more challenging to set up than I initially realised. That’s why, in this article, you’ll find real-life examples to help you understand the process.
Keep in mind that this article provides general advice only and does not constitute personal financial advice.
🤑Understanding Debt Recycling
What Is Debt Recycling?
Here’s how debt recycling works: Let’s say you have a $500,000 mortgage for the home that you live in and you have $100,000 to invest in shares. Because you live in your property, the interest you pay isn’t tax deductible.
But here’s where it gets interesting, and where debt recycling comes into the picture. Let’s say you use that $100,000 to repay your home loan. Then you’ll have a $400,000 mortgage and $100,000 worth of equity. You can then withdraw that $100,000 worth of equity and use it to invest in shares. And that means that the interest that you pay on this $100,000 that you have withdrawn to invest in shares is tax deductible.
The ATO has responded to this question about debt recycling, and they’ve said that they look at what the money is being used for. If you’re using the redraw amount to invest, the interest portion on that loan is tax deductible. You essentially have a $400,000 home loan, which isn’t tax deductible, and a $100,000 loan that you’ve used to invest in shares, which is tax deductible.
Key Benefits of Debt Recycling
You may be wondering: How much money do you save? In this example, if your mortgage interest rate is 6% and your marginal tax rate is 30%, that’s a tax saving of $1,800 per year. You can then use these savings to repay your home loan even more, and you can even use the dividends that you receive from your $100,000 share portfolio to repay your home loan faster. And then you just repeat the process until your home loan is paid off.
Who Can Benefit from Debt Recycling?
This strategy suits people who are already comfortable with the idea of investing and aren’t really looking to pay down their home loan straight away. Keep in mind that this strategy is different from borrowing and investing because you have the same amount of debt and the same amount of assets, you’re just doing it in a more tax-effective way.
🏠Theoretical Framework of Debt Recycling
How Debt Recycling Works in Theory
Debt recycling sounds great in theory, but how does it work in practice?
Let’s use Queenie as an example.
Queenie has a $680,000 mortgage for the home that she lives in. She’s saved up $20,000 to invest in shares. The first thing that she did was she called her bank to set up a separate $20,000 split on her mortgage. Her $680,000 mortgage was split into two portions: one for $660,000 and the other for $20,000. Creating this split just basically makes it easier to calculate which portion of the home loan is tax deductible and which portion of the home loan isn’t, because when the funds are mixed up, it can be a bit messy.
Then, Queenie opened up a transaction account attached to the $20,000 split. She now has a $660,000 mortgage with a transaction account and a $20,000 split with a transaction account. Instead of two accounts, she now has four accounts, but the total amount of debt that she has is the same at $680,000.
Because she has a $20,000 in savings that she would like to invest, she got her $20,000 in cash, she put it into the $20,000 split, and then she redrew $20,000. She then withdrew this $20,000. She put it into her investing app, Pearler, and she invested the $20,000 into ETFs. Now the interest that she pays on this $20,000 split is tax deductible since she would’ve used the money to invest in shares.
Potential Savings and Tax Benefits
Queenie’s mortgage interest rate is 6.3%, so she gets a tax deduction of $1,260 per year with this $20,000 split. And if her marginal tax rate is 30%, that’s a tax saving of $378 per year. One thing to note is that she has the same amount of debt as she did before, which is $680,000, except now her loan is split in two, instead of being lumped together. The benefit is that the $20,000 loan is tax deductible, and it’s separated from the rest of her mortgage, so it’s easy to calculate the tax deductions.
Once Queenie has another $20,000 to invest, she’ll do the same strategy: she’ll call up her bank and open up the third split with another $20,000, and then she’ll use her cash savings to pay down that $20,000 portion and then withdraw the same amount to invest.
So now we know how debt recycling works in theory and practice, let me give you some pros and cons.
✅Practical Steps to Implement Debt Recycling
Setting Up the Loan Split
With debt recycling you essentially have to throw dollar-cost averaging out the window. I do prefer dollar-cost averaging, which is investing smaller amounts of money more regularly. I like setting aside a nice chunk of my pay each month to invest. You can’t do this with debt recycling. With debt recycling, you need a pretty big lump sum to create that split.
Tracking and Managing Investments
One thing to note about debt recycling is if you already have some money invested into your Pearler account or any investing app for that matter, it is a good idea to invest in something different to what you’ve already invested in. For example, if you already have money invested in VGS, look at putting your debt-recycling money in VESG. It just makes it a bit easier for debt recycling and record-keeping and tax purposes.
🤔Challenges and Downsides of Debt Recycling
Time and Effort Required
The process of debt recycling can be a hassle. You have to make a lot of calls with banks to open the new loan split and the transaction account. These calls can take about 30 minutes each. The waiting game doesn’t stop there. You also have to wait until you have a big lump sum to create the new loan split. Unfortunately, the minimum amount isn’t too forgiving. Some banks have a minimum amount of $20,000.
Limited Benefits for Small Investments
In Queenie’s scenario because you only have $20,000 to invest, rather than $100,000 to invest, tax deductions aren’t that amazing to warrant all of this extra hassle. In the example, Queenie got a tax deduction of $1,260, which translates to $378 in tax savings, but to be honest, to go through all this extra hassle to save $378 isn’t worth it.
But I can see how debt recycling can become more worth it if you do have bigger amounts to invest and if you have been doing it for quite a long time, so you do have a sizable amount of your home loan that is tax deductible because you have used that money to invest.
Impact on Investment Psychology
Debt recycling also affects the psychology of investing because what I do like about dollar-cost averaging is I can essentially automatically invest that money straight into the stock market and not have to think about it. Whereas with debt recycling, it can be tempting to have a look at that $20,000 that you’ve saved up, that you still have in cash, and you may be more tempted to spend it rather than invest it. You also have to wait to have your money invested, so that’s another downside of debt recycling.
💭Final Thoughts
As this article highlights, there are many benefits as well as downsides to debt recycling. It’s super important to conduct a financial audit to determine if this strategy is suitable for you. If you’re still unsure about debt recycling and whether it’s the right approach for your situation, I’d strongly encourage you to consult with a financial advisor.
Debt recycling is a strategy that people use to pay off their mortgage faster and invest at the same time. It is a tax-effective strategy that can save you thousands.
Debt recycling suits people who are already comfortable with the idea of investing and aren’t really looking to pay down their home loan straight away.
The major benefit of debt recycling is that it allows you to convert a non-deductible debt, such as your mortgage, into a deductible debt through investing.
Yes, debt recycling can be done with a small mortgage.
Yes, there is an element of risk associated with debt recycling because it involves leveraging debt to invest.
