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The Most Exhaustive & Comprehensive Guide to Debt Recycling
You probably already know that in general bad debt is not a good debt to have whilst it would be beneficial to have good debt (just from the terminology alone). Less known perhaps, is the possibility of turning bad debt into good debt, especially if you want to grow your wealth and secure a bright financial future. Debt recycling is a strategy that can help you to successfully achieve this.
What exactly is the difference between a bad and good debt? Will debt recycling help turn one into the other?
Bad debt is not tax-deductible, implying that the asset doesn’t create an income or it is a depreciating asset. On the other hand, good debt is tax-deductible, meaning that you own an income producing asset that has the potential for capital growth.
Debt recycling involves utilising asset’s equity on bad debt to buy an investment asset with the aim of generating income. Once the income is generated, you can then use it to pay off non-tax-deductible loans. This is something you can repeatedly do till you are left with tax-deductible loans to pay. You can then rinse and repeat by selling the asset (say a house) and buying another more expensive house.
Don’t worry if this sounds complicated because this complete guide will take you through all you need to know about debt recycling whether you are beginning or someone who has used this strategy for many years, and how you can use it to achieve FIRE.
What is Debt Recycling
As I have mentioned earlier, debt recycling involves turning bad debt like credit card debt, the mortgage on a family home, or car loans into tax-deductible debt. The aim is to secure a brighter financial future and build wealth.
Debt recycling is a strategy that will allow you to leverage the equity in your non-tax-deductible asset and use it to invest in assets that can produce income. The idea is to take the income and use it to pay off the loan of the non-tax-deductible asset. Then repeat.
You might want to think this involves using a loan to settle another loan. However, it’s a cool strategy, especially for high-income earners who are likely to pay more taxes than what they would normally pay.
Debt recycling can help you build wealth in a more efficient way and also enjoy the benefits of investing. However, you must know that it can increase the risk you will encounter in the market. Therefore, before using the debt recycling strategy, you’ll need to assess your risk tolerance level and your financial goals.
You can work with a financial advisor to determine your risk tolerance and financial goals and determine if debt recycling is an ideal strategy for you.
How does it work?
The strategy works by using the equity in your home loan to invest assets that can produce and grow income. Over time, the income you generate from these investments will help you pay your home loan. The interesting thing is that it will make it a lot easier for you to pay off your home loan than when you make regular payments.
The interests on investment loans are tax-deductible. This means that the strategy can also help you create tax savings to use on your home loans. If the value of the investment increases, it will help you build your wealth faster.
The ultimate goal is to grow the investment loan to an equal amount to pay off the home loan and also reinvest the increased amount. You can repeat this process yearly until you have completely replaced your home loan with the investment loan.
Let’s now check out the methods you can utilise to achieve the conversion.
Debt Recycling – Two Broad Methods
1. Pay down non-deductible debt from income generating asset
a. Line of Credit (LOC)
A line of credit is a flexible loan that can be requested from a financial institution or bank. It is the amount of money (usually obtained via equity in your property) you have access to when needed and repays over a stated period of time. The LOC is a classical method of debt recycling. However, these loans are generally more expensive than other loans.
Like other types of loans, LOC will charge you interests, which you’ll also need to pay. However, the LOC tends to be a low-risk revenue source, unlike credit card loans.
Are you wondering how you can use a line of credit for debt recycling?
Imagine that your loan account is $450,000, and $15,000 has been paid off it. You can apply for a line of credit to make use of the equity.
You can invest $15,000 in an asset that can produce income. The next step you can use is to turn your home loan into a line of credit. This will give you flexibility, and you can access available equity and use it for investing. With this, you can continue applying for an increase in your investment loan while paying off the home loan. Over so many years of paying down the home loan and apply for the LOC increase, you could have a loan balance of $300k and LOC of $150k from a $450k loan.
b. Interest-Only Loans
This loan is similar to the line of credits, but there are few differences. The main difference is that unlike the line of credit, interest-only loans have cheaper interest rates. Also, it’s more flexible than principal and interest, easier to calculate your interest paid for the tax return; it’s approximate the same interest amount each month.
However, interest-only loans usually have higher interest rates than P+I, and they only last five years nowadays (whereas up to 15 years was possible in the past). Therefore, timing is important in terms of life events like having a kid and one partner out of work as it will be hard to refinance if you decide to do it at this time. You can also find it hard to refinance if you only just returned to work/started a new job as some providers require you to be back working for at least six months, especially if your pay check is not a constant amount each time e.g. shift, casual workers etc.
Here’s how debt recycling will work with interest-only loans:
The steps to follow if your interest-only home loan balance is $450,000 includes:
- Save decent lump cash, like $30,000
- Use it to pay down the loan to $420,000
- Apply for an investment loan of $30,000. When doing this, you must make sure the loan is not the same as the original loan.
You can then continue to pay your loan, knowing that $30,000 is tax-deductible. After a while, you can apply to increase the investment loan. The main advantage of interest-only loans is the lower interest rates you’ll get compared to the LOC and the choice to pay extra repayment if you wish.
Another amazing feature of interest-only loans is that you can use break the $450,000 loan from the beginning into multiple loan and offset accounts that will give you more flexibility and can be easier to track. i.e., with the $450,000, you generally have limited loan accounts (at least initially) to split the loan into say:
Loan 1: 200,000, Offset Account 1 e.g. $50k
Loan 2: $50,000, Offset Account 2
Loan 3: $50,000, Offset Account 3
Loan 4: $100,000, Offset Account 4
Loan 5: $50,000, Offset Account 5
What you would do here is keep all your savings in the offset account of the non-deductible debt (for now) which can be all the loan accounts shown above in the beginning so let’s use offset account 1 with $50k for this example. What you would do here is to transfer slightly less than $50k (say $49k) into loan 2 (for example) and redraw to your trading account if you want to purchase shares. Some accountants may say the money should go directly towards purchasing shares for it count (rather than have it land in your trading account) so please check with your accountant. Or you can buy an investment property. Some banks may have their own rule but usually if you pay off the entire loan in the loan account ($50k in this example), it will close automatically and you won’t be able to redraw from it anymore. You would then add the remainder ($1k) and redraw from the loan account to the relevant accounts as per above for either buying shares or investment property. You can then rename this loan account as say “Tax Deductible Loan Account 1” to track this and save the transaction records into your long term tax folder for record keeping.
i.e. Step 1:
Loan 1: 200,000, Offset Account 1: $1k
Loan 2: $1,000, Offset Account 2
Loan 3: $50,000, Offset Account 3
Loan 4: $100,000, Offset Account 4
Loan 5: $50,000, Offset Account 5
Trading Account: $49k
Step 2:
Loan 1: 200,000, Offset Account 1
Tax Deductible Loan: $50,000, Offset Account 2
Loan 3: $50,000, Offset Account 3
Loan 4: $100,000, Offset Account 4
Loan 5: $50,000, Offset Account 5
Trading Account: $50k
You then repeat the process for the other loan accounts until all the loan accounts are fully tax deductible. There may come a time where you may need refinance to another bank before all loans fully tax deductible so a helpful thing to do might to merge all the tax deductible loan accounts into one loan at the new loan provider. Also ensure you print off all transaction reports on the day of the settlement and keep it in a safe area. Please note that you may need to use a different strategy if it's a P+I as the principal for all loan accounts will be reducing which is why it's less flexible. The best strategy is to use one loan account, paying down the loan before applying for a split when you need it so there are no inefficiencies with more than one account reducing in principal. This is also how you would about it for a LOC.
So let’s just say you’ve paid off loan account 2-4 at this point. Your loan accounts at the new bank might look like the following:
Loan 1: 150,000
Loan 2: 200,000 (merge of loan 2-4 from the previous bank)
Loan 3: 50,000
Loan 4: 50,000 (taking $50k from the loan account 1 to make a new loan account)
This is the debt recycling set up as most property investor will know it. The dividend you receive every quarter or so from the $50k purchase in the trading account should arrive in your bank account which goes towards paying down the non-deductible debt (Loan 1, 3 or 4).
You may wonder why you need to have so much loan accounts if you don’t need to use it immediately. Some banks might be a bit of a hassle to do this and you have to fill out physical forms the old fashion way and requires all account holders to be present physically at a bank for identity validations. Of course, if the bank makes it as simple as clicking a few buttons then the above splits may not be necessary, at least initially. Sometimes you may want to use one account to pay property expenses which is another way you can make the loan account tax deductible. You do this by redrawing from the loan account and putting the money into the offset account and make all payments relevant to the investment property through this account.
The interest only strategy will help you to organise which loans are deductible and which ones aren’t. With this strategy, you can use the savings of not paying principal and interest towards either offsetting your loans or paying off loans and purchase more income producing assets. It allows you to be more strategic and adaptable as black swan events/unexpected situations occur.
c. Principal-and-Interest Loans
This is a commonly used debt recycling method, because home ownership used to be easier, considered less risky thus cheaper interest rates out of the three. I also believe this was due to the successful scare campaign of the significant increase to your monthly repayments once your interest only period ends.
This debt recycling method also works in a similar method to the two methods mentioned above, except instead paying one larger lump sum you may be doing a mix due to higher repayments. Like above, you just apply to access the equity from this. It offers lower flexibility because you will pay high monthly repayments which you may not want to do. Also, it may be harder to avoid mixing the loans, which may cause a tax ruling that the loan is not fully deductible. i.e. you will be paying the investment portion every repayment which means your tax deductions also reduces. The simple solution would be to ensure that it is a split loan with different loan accounts. If you’ve been doing this for awhile already you can undo the damage but you may need to do some maths to work out the %. Seek advice from your accountant if you’re uncomfortable doing this.
One thing to note about these types of loans is that repayments increases as the interest rate rises. Also, it may not be an ideal option if you prefer not to pay off a mortgage quickly. Say in the case that you want to inflate away your debt which is a common strategy for the wealthy.
2. Using proceeds from asset sales to pay down non-deductible debt
Most people know debt recycling to be one of the few types of number one above. This one is still used quite often though. To keep this section brief, you are basically selling off an asset to go towards paying down a non-deductible debt so you can redraw to buy more income producing assets. When used in combination with the PPOR CGT exemption and six years of absence, it can amplify wealth creation.
Let’s say you have a PPOR worth $1m with $500k owing, and you also have a couple of income producing investment properties. You sell one investment property with enough equity to pay all selling costs and the $500k non-deductible debt of the PPOR. Like the above example, you diversify and debt recycle into ETFs that yields you a cheeky $20k/year (excluding capital increase and franking credits).
Bringing It all together
Are you still wondering if debt recycling is worth the try? Here’s a quick guide to help you understand better:
You probably have paid a portion of your mortgage with any of the methods mentioned above, and the value of your home increased. The difference between the outstanding amount on your mortgage and your home’s current value is known as equity. If you can show serviceability, you might get up to 80% loan on your home’s value. You can then use your equity as security to take a new investment loan.
Assuming your home’s value is $450,000, and your equity is $100,000. You can recycle $80,000 of the equity as a loan. This means that you’d take an investment loan for $80,000 and use it as a deposit on any investment property, with your home equity as security.
Your loan value will now be $360,000 (80%), which is within lending parameters. You can invest $90,000 in an asset that can produce capital and income growth like an ETF or two, or investment property. You then use the income from this asset to pay down the non-deductible loan.
Tax Implications
Understanding the tax implications of generating income from these investments is key. In this case it’s pretty simple. As in the calculation is simple, not necessarily the idea/strategy. Firstly, on the income side. The equation below:
Net income increase = Distribution – Interest on tax deductible loan proportion – allowable deductions of specific investment (usually property expenses if it’s an IP)
If the resulting impact is an overall reduction in net income then this is known as negative gearing. This is another strategy whilst not recommended in all situation, can be advantageous when you use artificial deduction such as a depreciation schedule as you are not losing actual money to save on tax. It is also technically not debt recycling but thought it would be a consideration as initially it may not be possible so you would need to use your income to pay down the n0n-deductible loan.
The result of negative gearing is on your overall taxable income component such that you will pay:
Income Tax payable = (Taxable income before property + Net Income Increase) x tax bracket % + any absolute tax amount for the tax bracket
For example for a debt recycle into shares, if you earning a taxable income of $101k before net income from shares and receives $2500 distributions (disregard franking credits etc to keep it simple) with the cost of interest on the tax deduction proportion being $3500, the tax payable will be:
$101k - ($2500 - $3500) = $100k-90,001*37% + 20,797 = ~$24,497 overall tax
Versus if it was a net increase of $1k instead:
Tax payable = $1k x 0.37 = $370 tax on distribution
Here’s another example that can help you understand better:
Assuming you (in the 37% tax bracket) have a $500,000 house with an outstanding of $150,000 on your mortgage. Your take-home is $7000 monthly, and you can only afford $2000 monthly in interest payments and principle towards your mortgage. You can set up a debt recycling strategy that will help you apply for a loan that has a 100% offset to the value of $150,000 against the equity of your home. This is also referred to as splitting your home loan into two. With this, you can continue paying $2000 monthly to your mortgage and also use $2000 from your investment loan for a different investment. Let’s say that investment is an IP for this example.
Your non-tax deductible debt will decrease by $2000 each month, and your deductible debt will increase by $2000 because you are basically recycling your non-deductible debt into deductible debt. Assuming the interest rate is 2%, this is an annual interest amount of $3k. $150k can allow you buy an IP worth $750k (20%) if you are earning an appropriate income. Assuming 3% yield this is $22.5k/year and other property expense of $10k, the tax payable is:
Tax payable = 22,500 – 3,000 – 10,000 = $9500 x 37% = $3,515
The Power of Leverage and Compound Effect
Understanding the effects of compounding is another important thing, especially if it uses leverage in the investment strategy.
Here’s an illustration to help you understand better:
Suppose you have an equity of $250,000 that you can borrow for your investment over a period of 5 years; your end balance would be $319,070. This implies that you have generated a total return of $69,070.
Are you still confused? Here’s another illustration to help you understand the compound effect.
Say you have $100,000 to invest, and you are targeting a return of 200% and a growth rate of 20% annually. This means that after the first year, you’ll have $120,000. What you must note is that after another year, you’ll have an additional $24,000, which is 20% of $120,000, rather than 20% of the initial $100,000. With this, you only need four years to get to the 200% target. Now that’s how the compound effect works.
This means that with the $100,000, you may be able to buy a house worth as much as $1m, and if your property grows by 6%, that will be at least $60,000 equity. Whereas if you just buy shares immediately, you can only buy $100k worth. And you would only have 6k for the same amount invested. The NAB Equity Builder would require you to contribute 2.5x more than the above to purchase $1m worth of shares. This makes sense because in many way, shares are more volatile and have lower barriers to entry/exit. It is also less flexible because it is P+I.
By debt recycling, you can do both. Or you can buy another property. Let’s say you diversify into shares and 5% growth rate on the $1m house value after 4 years. It will be worth $1.22m so without paying off any additional amounts, you can use $93k to buy more income generating asset. Buying an ETF like VAS will yield you around $3.7k (excluding growth and franking credits) in the first year and of course more if you’ve been paying off some loans. If you subtract your interest rate % from the above return, it would still be a decent amount due to the low interest rate environment. In general, your return is:
Net Debt Recycle Return = Dividend + Growth + Franking Credits – Interest Rate
e.g. Net Debt Recycle Return = 4% + 3% + 1.5% - 3% = 5.5%
You will expect in general a comparatively better return nowadays as dividend return to it’s long-term average while interest rate has fallen.
Risks
Debt recycling is a high-risk strategy mainly because you’ll be using a loan to settle another loan. Therefore, you are likely to face financial stress if the interest rates increases or your investment does not perform well enough.
Here are some things you should consider before entering any investment:
Review your insurance coverage to be sure that it will be repaid if anything happens to you. Of course landlord insurance is a must but I also mean things like life insurance for the probability that you pass on and you next of kins have to take on your debt obligations.
It takes discipline and willpower to use tax savings and investment income for your home loan rather than spending it on luxury things like a vacation or even a new car.
Taking loans to invest can make you earn more when the markets are rising. However, what happens when the markets are falling? You will only incur losses (although only paper loss), and you will just be stuck paying for a loan that is no longer worth what you paid, and you may not be able to sell it unless you have extra savings.
Health issues and loss of employment/business failure, an unexpected situation where you may need money quickly, so having an emergency fund is important.
The value of assets you buy with loaned funds can fall, meaning that the value of tax deductions you receive can also fall. This means that you are in debt, even after you sell the asset.
For interest rates that are not fixed, any rise in interest rates will mean that your repayments will increase. This will only put much pressure on you, and it will even be worse if your investment income is not up to expectations.
Debt recycling is a great option to generate more wealth and settle your home loan fast. However, you need to consider the points highlighted above before anything. Debt recycling may work for you today and take a different turn tomorrow if you are not prepared.
Best Time to Use this Strategy
A PPOR (Primary Place of Residence) loan is not a good debt because the interests are not tax-deductible, and it doesn’t generate income. You can use the debt recycling strategy to recycle this type of debt and convert it into tax-deductible debt.
You can also use the earning to pay off other debt. This strategy will help you to build long-term wealth. However, you must note that there are many risks involved. You are likely to face financial stress if you don’t stress test your finances for when interest rates increases or your investment performs poorly.
Debt recycling isn’t a strategy for everyone. However, if you are sure that you want to use this strategy, you must be ready to bear the risks involved. You also need to be sure that your investment has every chance of performing, you have enough emergency fund, when to time your refinancing, and the stress testing interest rate rises to ensure you can cope if it does increase.
For the strategy to work, here are some tips:
A long-term horizon (10 years or more).
Build enough buffer to ensure you can fulfill debt repayments as they fall due to other potentially unexpected events (1 year emergency fund for personal and property expenses).
Willingness to hold concurrent loan and increase your debt.
Ensure the asset you bought from the proceeds of debt recycling is generating income.
Keep detailed records of the debt recycling, especially when you may refinance to different banks to ensure that any tax rulings will be in your favour.
Build the right team
Choose the right broker who will structure your loan correctly the first time. Ideally someone who has more than a few properties to their name
Choose the right accountant and ideally someone who has their own property portfolio and can comfortable describe in detail their strategy (which should include debt recycling)
Choose the right property manager (if debt recycling to IP) as recommended on propertychat.com.au as they will choose the right tenants and handle issues whilst allowing you sleep easy at night.
Choose the right insurance company. You don’t want to deal with anymore headaches after the reason of needing them in the first place.
Timing is everything, especially when you refinance. i.e. we refinanced close to my partner’s birth or just before we got a new job when the interest only loan expiry was approaching or we wanted better rates
Follow my monthly Frugal and Financial Newsletter to ensure your current rates are not too far off the mark.
Once loan is fully tax deductible, use my mortgage widget and FIRE Number widget to help you decide whether to sell the property or pay it down fully.
Ensure you have an exit plan when FIRE is nearing.
Pros and Cons
Pros
Just like every other financial strategy, debt recycling also has its own benefits. However, this depends on your income, future financial goals, and financial situation.
The main benefit of debt recycling is that it will help you build your investment portfolio and also grow wealth at a faster rate compared to other traditional methods. You are able to start as soon that first income hits your account if you wish.
With traditional methods, you can only build an investment portfolio after you have paid off the mortgage on your home. You can take this route, but that will mean forfeiting the compounding returns you would normally get when you start an investment. Also, you’re likely to spend so many years before you finally pay off the loan, and this can make it harder for you to achieve your financial goals.
Also, with the compounding effect, it may not necessarily take a long time to pay off loans. If you’re a high earner, it can be paid off very quickly. Houses are also a good inflation shield, and this implies that you can let inflation pay off your house too.
This strategy will help you maximise tax benefits and minimise tax obligations. Debt recycling is cost-effective when compared with conventional strategies. The strategy is more profitable when the marginal tax rate is higher.
What’s more, is that you can use debt recycling to build a different investment portfolio. It’s a nice way to earn extra money to use in reinvesting to different investment assets and shares to build that dream diversified portfolio.
Debt recycling should benefit most people who use it than if they don’t. It is also effective for people with large and secure incomes because they can comfortably pay/offset both loans quickly if they wish while enjoying the tax advantages and continue to use debt to buy investments. It is important to note that falling into this category doesn’t automatically mean you have the complete protection you need to ensure that you can meet the loan repayments. Unexpected health issues can derail it all.
Cons
Debt recycling offers several benefits, but there are still a few downsides. You cannot afford to ignore these downsides if your strategy is not properly structured or lacks an income that can support you.
The first thing you should consider before you decide to use debt recycling is to know that are your returns are compounded, you are also likely to suffer losses. This is because with two debts in two investment assets if the market experiences a negative turn, you’ll experience a huge fall.
Another thing you might want to consider is the fact that the asset you are leveraging on is your home. This means that you need to consider whether you are ready to take that type of risk. The high level of risk involved in debt recycling is the major reason why it is only recommended as a long-term strategy. This is to create enough time so you can recover if the market crashes. The strategy is not suitable for people with an investment strategy that’s less than several years. Like most investments really.
The main feature that will determine whether the benefits outweigh the risk is its effect on your current financial situation and your investment goals. That’s why it is best to discuss debt recycling with a financial advisor before you make any decision. We personally used our broker and accountant for this and highly recommend this route.
Summary
Debt recycling is a great strategy to simultaneously pay your home loan and build your investment portfolio that allows you to FIRE. There are many things to consider if you want to get the best of debt recycling and hopefully guide provides more than enough to help you on your journey.
Are you still wondering if this strategy is worth it? Depending on how well you tolerate risks and your goals, debt recycling may not be a perfect strategy for you. It will only be a good strategy for you if you are happy to venture into it for the long term, have enough emergency fund (I recommend 1 year of personal and investment expenses) and have a stable income source.
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