What is debt recycling?
Debt recycling is a financial strategy that helps you pay off your home loan faster while potentially building long-term wealth. It’s often used to turn your regular mortgage debt, which isn’t tax-deductible, into investment debt that may allow you to claim tax deductions. Many Australians use debt recycling to make better use of their home equity. Instead of just making repayments and waiting for the loan to shrink, you can borrow against the value of your home and invest that money in assets that earn income, like property or shares. Over time, the income from those investments, along with possible tax savings, can help you reduce your mortgage more quickly.
How does debt recycling in Australia work?
Debt recycling is not a one-step process. It involves a series of actions that work together to reduce your mortgage while building an investment portfolio. This strategy is often used by people who already have a home loan for a principal place of residence (PPOR) and want to make their money work harder. Here’s how it typically works:
1. Build equity in your home
Let’s say you have money sitting in an offset account. This helps reduce the interest you pay on your home loan. You use that money to pay down part of your mortgage, increasing the equity you have available to borrow against.
2. Access that equity
You now use a split loan or a line of credit to borrow the amount you paid down, but this time as an investment loan.
3. Invest the borrowed funds
You then invest the money in income-producing assets such as shares, managed funds, or property investments. These investments aim to generate returns over time.
4. Claim tax deductions
Because the borrowed funds are used for investment purposes, the interest on this loan may be tax-deductible. This can reduce your overall tax bill.
5. Use returns and tax savings to pay down your mortgage
Any income from your investments, along with tax savings, can be directed back into your home loan. This helps you pay it off faster while continuing to grow your investments.
If you’re considering this strategy, it’s important to choose the right home loan structure. Speak to home loan expert so you can set your accounts up correctly. Debt recycling also involves tax implications and investment risk. A qualified financial planner or accountant can help you structure the strategy correctly and ensure it aligns with your goals.
Benefits of debt recycling
Pay off your mortgage sooner
By using investment income and tax savings to make extra repayments, you can reduce your home loan term significantly. This means you could become debt-free years earlier than planned.
Build wealth through investments
Investing borrowed funds in assets like shares or property gives you the chance to grow your wealth over time. Property investment is appealing because it can provide rental income and potential capital growth.
Convert bad debt into good debt
Home loan interest is not tax-deductible, but investment loan interest often is. By shifting some of your debt into an investment loan, you may be able to claim tax deductions, improving your overall financial position.
Risks of debt recycling
Market volatility
Investments like shares and property can rise and fall in value. If your investments underperform, you may still owe the borrowed amount, which could put pressure on your finances.
Interest rate changes
If interest rates increase, the cost of your investment loan will rise. This can reduce the benefits of debt recycling and make it harder to manage repayments.
Cash flow discipline
Debt recycling requires a steady income and careful budgeting. If you miss repayments or spend investment income instead of using it to reduce your mortgage, the strategy won’t work as intended.
Example scenario: the upside and downside of debt recycling
Emma and Daniel have a $700,000 home loan and $250,000 in their offset account. They use the $250,000 to pay down a portion of their loan. This leaves them with a remaining balance of $450,000 on their mortgage.
They decide to use $100,000 of the equity through a split loan to buy an investment property worth $500,000.
The potential benefits
The possible risks
Emma and Daniel manage because they planned for these risks with a cash buffer and a long-term outlook. But without that preparation, the extra costs and lost income could have put serious pressure on their finances.
What to consider before you start debt recycling
Debt recycling is not a one-size-fits-all strategy. Here are the key factors to weigh before you begin:
Financial position
Debt recycling works best when you’ve built equity by paying down your home loan over time, and your property’s value has increased. This gives you room to borrow for investments without overextending.
Investment choices
Decide where to invest borrowed funds - shares, managed funds, or property. Property can offer rental income and long-term growth, but it also comes with ongoing costs like maintenance, insurance, and periods without tenants.
Your risk tolerance
Debt recycling involves borrowing to invest, which means exposure to market changes. Property values can fall, interest rates can rise, and rental income isn’t guaranteed. Be prepared for these fluctuations.
Your time horizon
This strategy works best over 10 years or more. If you plan to sell your home or investment property soon, debt recycling may not be suitable.
Your safety net
Have a financial buffer for unexpected costs - such as repairs, vacancies, or interest rate hikes. A cash reserve can prevent stress if things don’t go as planned.
Is debt recycling right for you?
Debt recycling can help you pay off your mortgage faster while building wealth, but it’s not without risks. It works best if you have a solid financial base, a long-term outlook, and a clear plan for managing cash flow. If you’re thinking about using this strategy to invest in property, it’s crucial to speak to a financial advisor or accountant to check if it's a good fit for your circumstances. To understand your loan structure and avoid costly mistakes, we also recommend speaking with a home loan expert.
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The information contained in this article is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, financial and taxation advice before acting on any information in this article.
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