Debt recycling offers a unique way for homeowners to turn their mortgage debt into a potential wealth-building opportunity. If you’re wondering what debt recycling is, how it works, and whether it’s right for you, you’re in the right place. This debt recycling guide will cover everything you need to know, from debt recycling explained in simple terms to the steps to effectively recycle debt.
What Is Debt Recycling?
Debt recycling in Australia is a financial strategy that involves replacing your home loan debt (non-tax-deductible) with investment debt (tax-deductible), potentially generating income that can accelerate your mortgage repayments and improve your position over time.
The concept of debt recycling revolves around borrowing funds against your existing home equity to invest in income-generating assets, such as shares or managed funds. You then take the dividends along with your tax savings and other savings to pay more towards your mortgage. The end goal is to significantly reduce or finish paying off your home loan while having multiple income-generating investments in your portfolio.
Who Is Debt Recycling Suitable For?
Debt recycling is most suitable for individuals who:
- Have significant equity in their home.
- Are comfortable with a higher level of financial risk.
- Have a stable income that allows for additional borrowing and investing.
- Understand the long-term nature of the strategy.
Why Consider Debt Recycling?
Debt recycling is attractive for several reasons:
- Tax Benefits: One of the most significant advantages of debt recycling is the potential tax benefit. The interest on an investment loan is tax-deductible, whereas the interest on a home loan is not. Note: you should always undertake debt recycling with the guidance of an accountant or appropriate financial professional.
- Wealth Building: By using borrowed funds to invest, you have the potential to build wealth faster than by simply paying off your home loan.
- Accelerated Mortgage Reduction: By using tax savings and returns from your investments to pay down your home loan, you could potentially pay off your mortgage sooner.
Risks of Debt Recycling
While debt recycling can offer tax advantages and help build wealth, it also comes with inherent risks that you need to be aware of:
- Market Risk: The success of debt recycling depends on the performance of your investments. If the investments perform poorly, you could end up with high-interest investment debt without corresponding gains.
- Requires Patience: Debt recycling is not a short-term strategy. It may take years before you see significant results, so you should only consider it if you’re willing to wait and be consistent.
- Requires Discipline: This strategy requires financial discipline as you will need to continuously repay your mortgage while managing investments.
How to Debt Recycle in Australia
Here are the steps to debt recycle effectively:
1. Assess Your Financial Position
Before embarking on a debt recycling journey, assess your current financial situation. Are you comfortable with your existing home loan repayments? Do you have sufficient income and cash flow to manage additional borrowing?
2. Build Up Equity
To begin debt recycling, you need plenty of equity in your home. Take a significant amount of cash (from your savings, offset account, or other sources) and use it to pay down your mortgage and increase your equity. Now, you have decreased your non-deductible debt.
3. Borrow Against the Equity of Your Home
Now that you have built up equity in your home, you take out a loan of the same amount you paid down. Let’s say you used $100,000 of your savings to pay your mortgage. You should also borrow $100,000 secured against the equity of your home.
4. Invest Wisely
Use the borrowed funds to invest in income-generating assets like shares or investment properties. The key is to ensure that these investments align with your financial objectives and risk tolerance. By doing this, you now turned your non-deductible debt into deductible debt.
5. Use Savings, Tax Savings, and Investment Income to Pay Down the Home Loan
Now, repeat the cycle by paying down your home loan once again. Use your savings, the income generated from your investments, and your tax savings to pay your mortgage.
6. Repeat the Cycle
Repeat the cycle by borrowing again against your increased equity and investing the funds. This cycle of borrowing, investing, and repaying continues until your non-deductible home loan debt is fully replaced with investment debt.
7. Monitor and Adjust
Debt recycling is a long-term strategy that requires careful monitoring. Financial markets are unpredictable, and it’s crucial to adjust your investments if necessary to reduce risks. Regularly consult with a financial advisor to ensure the strategy continues to align with your goals.
What to Consider Before Debt Recycling
Before utilising this strategy, here are some factors you need to consider:
- Risk Tolerance: Investments linked to debt recycling, such as shares or property, carry risks, including market volatility and potential losses. Assess your comfort level with taking on risk and your ability to manage financial stress during market downturns.
- Investment Knowledge and Goals: Understand the types of investments you will make and the associated risks and returns. Ensure your investment strategy aligns with your long-term financial goals, such as wealth creation or retirement planning.
- Cash Flow Management Effective: Cash flow management is critical to handling loan repayments and investment contributions. Assess whether you have sufficient disposable income or surplus funds to maintain the strategy without financial strain.
- Tax Implications: The primary benefit of debt recycling is converting non-deductible debt (home loan) into deductible debt (investment loan), leading to tax advantages. Understand the tax rules surrounding interest deductibility and ensure your investments qualify for deductions.
- Timeline: Debt recycling is a long-term strategy that requires time for investments to grow and provide significant returns. Ensure you have a long-term outlook and do not anticipate needing the invested funds in the short term.
- Emergency Fund: Maintain an emergency fund to cover unexpected expenses or financial setbacks without disrupting the debt recycling process. A solid financial safety net reduces the risk of relying on credit during emergencies.
- Economic Conditions: Broader economic factors, such as market conditions, inflation, and government policies, can influence both your investments and borrowing costs. Stay informed about these factors to make timely adjustments to your strategy.
Is Debt Recycling Right for You?
Debt recycling can be an effective way to create wealth and pay off your mortgage faster, but it’s not suitable for everyone. Before deciding to embark on this strategy, consider the following:
- Your Risk Tolerance: Debt recycling involves borrowing to invest, which comes with investment risks. Be sure you are comfortable with the possibility of losing money.
- Your Financial Situation: Ensure that your income is stable and sufficient to cover both mortgage repayments and the costs of borrowing to invest.
- Professional Advice: Consult a financial advisor to assess your suitability for debt recycling. They can help you understand the potential benefits and risks based on your specific situation.
Debt Recycling ATO Ruling: Is it Legal?
There’s a common misconception that debt recycling bypasses or skirts taxation laws in Australia. The truth is debt recycling is well-recognised and is a legitimate strategy for reducing non-deductible debt with deductible debt. When recycling debt, it’s crucial to follow tax laws, especially when using funds to borrow for investments. For the interest on the borrowed funds to be tax-deductible, the money must be used exclusively for income-producing investments.
Getting Started: Use a Debt Recycling Calculator
Before getting started, you can assess whether debt recycling is for you through the use of a debt recycling calculator. This tool can be helpful to determine the potential financial benefits of this strategy.
Enter details such as your income, initial investment, mortgage details, and details about your investments. Our calculator will then provide a potential illustration on how much you’re projected to save on tax deductions within your timeline. You can then get a better understanding of how debt recycling might impact your finances over time.
Important Disclaimer: The debt recycling calculator is for illustrative purposes and is not to be relied upon for any reason. It’s important to remember that our calculator provides estimates and are based on certain assumptions. The calculator does not take into account your circumstances and actual results can and will vary, depending on changes in interest rates, investment returns, and market conditions.
Final Thoughts
Debt recycling in Australia can be a powerful wealth-building strategy, but it requires careful planning and management. By turning your non-deductible home loan into a tax-deductible investment loan, you could potentially accelerate your mortgage reduction while building a portfolio of income-generating assets. However, as with all financial strategies involving debt, there are risks that need to be carefully considered.
Start Your Debt Recycling Journey Today
We at Dark Horse Financial are experts in lending and investments. If you’re ready to take the step to a better financial future, reach out to us today and we’ll get you started.
