Debt recycling is a strategic approach to converting non-deductible debt into deductible debt, allowing you to reduce tax while growing your wealth. When implemented correctly, it can be a very powerful tool to accelerate wealth creation.
In this guide, we’ll explore how debt recycling works, who it’s best suited for, and the key benefits and risks to consider.
What is Debt Recycling?
Debt recycling involves using the equity in your home to invest in income-generating assets while systematically paying down your non-deductible mortgage. Over time, your non-deductible debt decreases while your deductible investment debt and asset portfolio grow.
This strategy is particularly effective for those who have strong cash flow and a high marginal tax rate.
How Debt Recycling Works
Before getting started with debt recycling, it’s important to ensure you meet certain criteria to make the strategy viable and effective.
To start, your home loan balance should be less than 80% of your property’s value to ensure you have usable equity without paying Lenders Mortgage Insurance (LMI).
You also need to have a strong appetite for risk and a long investment timeframe. Using debt for investing is not for the faint-hearted. It can magnify both potential gains and losses.
Finally, having a reliable cash flow is crucial to comfortably manage loan repayments, even if interest rates rise. We stress test every client scenario assuming a 2% increase in interest rates and a 20% increase in expenses to ensure they have the capacity to weather future storms.
How the Process Works
To implement a debt recycling strategy, consider the following steps:
- Access equity – Set up an investment loan (separate from your home loan) using the equity in your property.
- Invest the borrowed funds – Choose income-producing assets such as ETFs, LICs, managed funds, or dividend stocks.
- Use investment income to pay down your home loan – Any income generated from your investment is redirected to reduce your non-deductible mortgage.
- Re-borrow to invest – As your home loan decreases, you borrow more to invest, continuing the cycle.
- End result – Over time, your home loan is eliminated, and you’re left with a diversified investment portfolio and a tax-deductible investment loan.
Benefits of Debt Recycling
The primary benefit of a debt recycling strategy is that it turns non-deductible debt into deductible debt. Why is this important? Because the net cost of deductible debt (the cost after factoring in the tax benefit) is cheaper than that of non-deductible debt.
By focusing on income producing assets as your chosen investment, these assets will provide additional cash flow to accelerate the repayment of the non-deductible debt.
In addition, you are building an investment portfolio that can compound over time. Once your mortgage is paid off, your investment income can support lifestyle expenses or further investments. This helps put you on the path to financial independence.
Risks of Debt Recycling
However, debt recycling comes with risks which shouldn’t be overlooked.
Any time you borrow for investing, you are magnifying your potential return. In order for the strategy to be effective, you need to be confident that over the medium to long term, the return you generate on the investments is greater than the interest rate on the loan.
Market fluctuations can impact your investments, and poor performance may leave you with a loan but no returns. For example, if a downturn occurs, the value of your investment could drop significantly, potentially leaving you in a situation where your loan balance exceeds your asset value.
Rising interest rates can also increase borrowing costs, making the strategy less effective. Before starting, you should ensure loan repayments are manageable, even if your income decreases or investment returns fluctuate.
Lastly, setting up an investment loan may involve additional fees and borrowing costs. You need to talk to your lender or mortgage broker about these costs before implementing the strategy.
Who Should Consider Debt Recycling?
Debt recycling is best suited for long-term investors, particularly those at least 10 years away from retirement who can commit to the strategy for over seven years.
It’s also ideal for individuals with a high tolerance for risk, as borrowing to invest magnifies both gains and losses. Financial discipline is crucial, as understanding investments or working with a financial adviser ensures the strategy is executed effectively.
The Guided Investor approach
Here at Guided Investor, we consider debt recycling in Phase 2 of Wealth Creation – when we are implementing aggressive wealth accumulation strategies to achieve financial independence.
While debt recycling can be a powerful way to grow wealth and enhance tax efficiency, it’s not for everyone. It may not be suitable for those close to retirement, individuals with low risk tolerance, or those without the financial stability to manage additional debt. It requires careful planning, discipline, and a solid understanding of investment principles.
