How debt recycling works

• Interested in debt recycling to pay off your home loan faster?
• How debt recycling works and how to go about it.
• Pros and cons of debt recycling.

If you want to change the way you pay off your home loan, converting your debt from non tax-deductible to tax deductible, debt recycling could be an option. It’s an interesting and potentially very beneficial strategy, but it’s not without risk.

We take an in-depth look at debt recycling, including who can do it, its tax implications and its benefits and risks.

What is debt recycling?

Debt recycling is a method of paying off your home loan by using equity in your home to invest in assets that produce income (such as shares and ETFs). The idea is to take the income from your investments and pay it towards your home loan, meaning you can pay off your loan faster than if you were making just regular monthly repayments.

As you pay off your mortgage, you are increasing the equity in your home, meaning you can borrow more money against your property and invest it again.

At the same time, you are shifting the non tax-deductible debt of your home loan to the tax-deductible debt of an investment loan.

How it works

The best way to explain how debt recycling works is to use an example.

Let’s say your home is worth $600,000 and your remaining mortgage is $300,000.

In theory you have $300,000 of equity you can borrow, but most lenders will only lend you 80% of the value of your home (a ratio known as the LVR), minus your mortgage.

Eighty per cent of $600,000 is $480,000. Take the $300,00 of your mortgage away from that, and you are left with usable equity of $180,000.

Next, you take out $100,000 of that equity as a tax-deductible investment loan and put it into income-earning assets such as shares, ETFs and mutual funds.

Over the next year, your investments increase in value by $8,000 and yield an income of $6,000.

You take that $6,000 of investment income and put it towards paying off your mortgage. Added to regular principal repayments on your mortgage totalling $10,000, you reduce your mortgage by $16,000 in the year.

This has of course increased the equity in your home and you then take out that $16,000 in additional equity and invest it again into more income-earning assets.

The process is repeated until your mortgage is paid off.

Who can do it?

Not everyone is able to go down the debt recycling route. There are some prerequisites you need to meet before you can start your debt recycling journey.

These are:

• Equity in your home, and a home loan. Without equity in your home, you won’t be able to borrow further funds against it.
• A regular income that is separate from your debt recycling plan. You will need this income to cover the interest repayments on your investment loan if they are not covered by dividends or other investment income.
• A reasonable appetite for risk. There is risk involved in debt recycling, including the possibility your investments might tank. You also might have to be prepared to ride out some significant market fluctuations.
• A long-term strategy. You will need to be able to invest in this strategy for at least seven years for it to be effective. In other words, don’t add further risk by short-term trading.

Tax implications

Although one of the key benefits of debt recycling is that the interest on your investment loan is usually tax-deductible, there are tax implications on your realised capital gains from your investments.

For example, when you sell any shares at a profit, you will incur Capital Gains Tax. The tax office considers any profits from share sales as part of your income and they will be taxed at your marginal tax rate after including any other income you earn.

Benefits vs risk assessment