What is Debt Recycling
Debt Recycling isn’t quite like recycling your newspapers or bottles, but much as they are good for the environment, this is good for your wallet.
Debt recycling is the process of turning non-deductible debt into deductible debt.
It works to save you money because interest paid on debt used to fund an investment is tax deductible, whereas interest paid on your home loan is not.
In practice, this means that if you have $10,000 to invest, you could use it to invest (maybe buy shares), or to pay off your home loan, or even make additional contributions to your super fund. I’ve previously written about this choice.
Alternatively, you could mix the first two of these options.
That is you could use the $10,000 you have saved to repay some of the outstanding balance on your home loan, then redraw $10,000 on your home loan and use that money to invest in the same shares.
By doing this, nothing has really changed.
You still owe the same amount on your home loan and you still have the same $10,000 shares. But now the interest on the $10,000 is tax deductible.
That’s why it’s called debt recycling.
The numbers at a glance
Here’s how the numbers look:
Suzie has a salary of $90,000. She pays tax of $22,150 (32.5% plus 2% Medicare
levy), leaving after tax income of $67,850. She has a home loan balance of $400,000
at 5.64% interest, so she pays $22,560 interest in a year.
She has saved $10,000 to invest in shares and plans to add $500 per month to this
investment. The investment that Suzie is considering is a high growth diversified fund with a total growth rate of 8.42% that consists of a capital growth component of 3.11% and income of 5.30% per annum.
| Scenario A (without debt recycling) |
Scenario B (with debt recycling) |
|
| Home Loan Balance | $400,000 | $390,000 |
| Investment Loan | NIL | $10,000 |
| Total Debt | $400,000 | $400,000 |
| Shares | $10,000 | $10,000 |
- In scenario A, she uses the $10,000 to buy the shares.
- In scenario B, she uses the $10,000 to reduce her home loan to $390,000 and then redraws $10,000, which she uses to invest.
Her personal balance sheet is no different. She has the same assets and the same debts.
When you debt recycle there is no change to your assets or liabilities.
But when you look at Suzie’s income, things change for the better:
| Scenario A (without debt recycling) |
Scenario B (with debt recycling) |
|
| Salary | $90,000 | $90,000 |
| Dividends | $530 | $530 |
| Investment Interest Paid | NIL | ($564) |
| Taxable Income | $90,530 | $89,966 |
| Tax Payable | ($21,700) | ($21,505) |
| After Tax Income | $68,830 | $68,461 |
| Balance of home loan interest | $22,560 | $21,996 |
| Cash after home loan | $46,270 | $46,465 |
| Net benefit | - | $195 |
The benefit of $195 after tax is the equivalent of earning an extra 1.95% on her
investment of $10,000 after tax.
The higher your tax rate, the bigger the benefit.
This means that if you are investing and still have money owing on your home loan, you will usually be better off if you use the funds to pay down your home loan and invest using funds redrawn from your home loan.
Below is a practical example of the effect using debt recycling compared to paying of your home loan or investing in your personal capacity.
Over a 10-year period the Suzie will have contributed a total of $70,000 that consists
of the original $10,000 together with the $500 per month.
| Scenario A (pay down home loan) |
Scenario B (without debt recycling) |
Scenario C (with debt recycling) |
|
| Contributions made |
$70,000 |
$70,000 |
$70,000 |
| After 10 years |
$97,912 |
$100,367 |
$108,894 |
| After Tax Return pa. |
5.71% |
6.12% |
7.48% |
The difference between paying off your home loan or investing in your personal capacity without debt recycling is immaterial. However, using debt recycling and generating deductible interest that can be offset against investment income, the difference is sizable as you may have $8,527 more when compared to an investment
without debt recycling or $10,982 compared to paying off your home loan.
How to do this in practice
1. Decide if it’s for you
- If you have saved up some cash and you have a home loan on your home (not an investment property)
- The balance outstanding on your home loan is less than 80% of the valuation of your home.
- Decide if you want to invest or pay down the home loan
- If you decide to invest, then consider debt recycling
2. Make sure you set it up properly
Interest is only tax deductible if it is used to acquire an investment or to refinance a loan previously used to acquire an investment.
It is vital that the flow of funds from the draw down on the loan to the purchase or refinance is clear and the funds do not get mixed in with funds on which the interest is not deductible.
This means the borrowed funds should never be placed in an offset account prior to being invested.
It also means that you should have a separate loan account (or split) for the investment portion.
Now might be a great time to review your home loan, to make sure it's right for you and your debt recycling activities.
3. Step by Step
- Step #1: Take the $10,000 you have saved and make a repayment on your home loan.
- Step#2: Ask your lender to create a separate split for the undrawn portion of your limit (now increased by $10,000). Most banks will allow you to split your loan into as many separate facilities as you need.
- Step #3: Draw the $10,000 and transfer directly to the cash account associated with your share trading account.
- Step#4: Never deposit other monies in this split
- Step#5: try to make the split interest only to maximise the benefit – although be careful of paying a higher interest rate for this feature. Your financial planner or accountant will help you assess if the tax benefit exceeds the cost.
- Step# 6: Enjoy the benefit
4. Tips to get more from your debt recycling
Make sure the extra redraw is a separate facility.
The extra split is usually best structured as an interest only facility to maximise your deductible interest.
A good broker will help you set this up for worry free debt recycling. Your Life Sherpa will help you get the right loan at the right price and give you cash back
A tax deduction is never a good reason to invest in anything. Don’t confuse debt recycling and geared investing.
Let Life Sherpa help you get the right loan
Get help with choosing a better mortgage for debt recycling
The right loan at the right rate AND cash back
Chat to an adviser now
Vince Scully
Founder and Chief Sherpa
With over 25 years in Financial Services from consulting to management, Vince Scully is the go-to guy for wealth management and financial advice. Vince founded the Calliva Group; a fund manager, product issuer, advisor and lender to Government and private clients. Vince is an advisor to the Wealth Management Industry, and prior to his role as CEO at Calliva, a senior member of Macquarie bank’s infrastructure team.
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