Debt recycling gets talked about a lot. But written about? Not so much.

And this is a topic I get asked about all the time. So today, I’ll offer my thoughts on debt recycling, and cover some things that I see missing from the conversation.

Hopefully, by the end of it, you’ll at least have a good idea whether debt recycling feels right for you. There’s quite a lot to discuss, so let’s get started!

Debt Recycling – What is it?

Debt recycling is a way to turn your current non-deductible debt (your home loan), and turn it into tax deductible debt.

Sign me up, right?

Not so fast. There’s a number of things to think about first, which we’ll get into soon. But it’s a completely legitimate way to manage your debt.

First, let’s get something out of the way. It’s not about what the debt is attached to (your home), it’s about what the debt is used for (in this case investing). This is what determines whether the debt is tax deductible or not.

I know people who’ve taken equity out of their investment property to buy a car, and they think it’s tax deductible because it’s debt against the investment property. No!

Any debt used for personal purposes is not tax deductible.

How Does Debt Recycling Work?

Generally speaking, it involves paying down your home loan, while at the same time, pulling that money back out to use for investing, thereby making that portion of the loan tax deductible.

Or, accessing equity in the property to be used as an investment loan to invest in income producing assets, like shares.

Importantly, and almost nobody mentions this…

You need to be able to cover the monthly expense of this new loan out of your current cashflow.

The income from shares (dividends), combined with any other savings you have, are then used to pay down your home mortgage. Now your home loan will be lower.

You then apply to increase your investment loan (a few ways to do this), to invest this new equity into more income producing assets. Your investments will now generate more income to pay down your home loan. And then you can apply to access this new equity again.

As a picture, it looks like this…

(click to expand, includes instructions, courtesy of Peter Thornhill)

In a scenario like this, over time your home loans shrinks, and your investment loan grows. Eventually your entire loan will be for investment purposes and therefore tax deductible against your investment income.

We’ll take a look at the exact ways to do it shortly. But first, a word of warning…

A Word of Warning

Sometimes this is spoke of as a magic way to pay off your home loan and build wealth at the same time. While that can be true, it’s simply not suited to everyone.

First, you need to have a decent amount of cashflow or savings each month for this to work. And if you don’t, then there’s no magical strategy that’s going to solve your problems for you.

The fact is, you need to focus on saving first.

In a way, debt recycling can be seen as tinkering around the edges. Because if you’re already a good saver, you don’t need leverage to get rich.

As always, there’s a Warren Buffett quote for the topic of debt. It goes something like this…

“If you’re smart, you don’t need it. And if you’re stupid, you’ve got no business using it”. Also, “debt is the only way a smart person can go broke”.

So here’s my view. Debt, or debt recycling, won’t magically help you reach your goals. Stay focused on building cashflow, rather than equity, to create your freedom. The worries about tax are way, way overdone. Dividend investing is surprisingly tax efficient.

Things to Remember

Most of the information I’ve come across about debt recycling was written at least a few years ago.

And back then, you could get almost any loan you wanted and the interest rate was roughly the same. But the finance and lending landscape has changed a lot since then. What was possible before, is very difficult today.

For example, Interest Only loans are harder to get and the rates are higher. Line Of Credit home loans are even more expensive. And serviceability is much tougher for all loans.

This means you need more income to qualify for the same mortgage.

Also, you now must prove your level of household spending. No longer will the banks accept a ‘bare minimum’ level of spending (which was always unrealistic considering how much people spend!).

Due to higher interest rates on the more flexible loans, this somewhat dilutes the benefit of debt recycling straight away.

Principal and Interest loans are the cheapest option, but that kills your cashflow and is far from optimal for debt recycling. Because it means higher repayments and your overall loan balance going down, which is usually not the goal here.

Anyway, here’s your options in today’s lending environment…

Different Ways To Do Debt Recycling

Line of Credit

The first method and the classic way of doing debt recycling is by using a ‘Line of Credit’ home loan.

You’ll need to apply for this specially, or refinance from whatever you have right now.

Here’s the problem. Interest rates on this type of loan have gone up (relative to other loans). With most lenders, you’re looking at a rate of well over 5%.

This compares to a plain old Owner Occupied Principal & Interest mortgage, where you can easily get rates from 3.5% to 4%.

Although, there are some lower cost lenders, but these will be few and far between. Here’s what I could find for Line of Credit loans…

State Custodians who currently charge around 4%, Aussie who charge 4.5%, and Homeloans.com.au who charge 4.75% at the time of writing.

So you’re looking at a costly upgrade to get this type of loan. Once you’ve got it though, the facility should be pretty easy to use.

Think of it like a big credit card. With this loan, you’ll only ever have to pay the interest that is due monthly.

As soon as you pay any extra, your loan balance will reduce. But now it will show ‘funds available’, for you to redraw.

Debt Recycling with a Line of Credit

How does it work in practice?

Well, this loan is kind of like paying interest only forever. And you can start with the loan you have or you can apply to borrow more.

We’ll assume you have a regular home loan with a limit of $300,000, and have paid off $10,000 recently. Then you’ve applied for a Line of Credit to get the ball rolling.

Overall debt limit – $300,000

Home loan balance – $290,000

Line of Credit – $0

Available funds – $10,000

*When you start, you’ll need to make sure this Line of Credit is flexible so that you can draw the additional funds out as your regular home loan balance reduces.

So as you save money every paycheck, throw it into your regular home loan. Now your home loan balance will be lower, and more funds will be available in your Line of Credit.

After a short while, there should be a decent amount there as ‘available funds’. Your position will then look like this…

Think of this as your debt having two sides. So as you pay money into the ‘home loan’ side, straight away it becomes available for you to pull out from the ‘Line of Credit’ side. All while your overall debt limit stays the same. You with me?

You can now withdraw additional funds for investing as soon as you pay down bits of the mortgage. Note, for tax purposes, the funds must go directly to your investment account to buy shares – no detours!

At this point you simply keep saving, paying down the home loan and withdrawing the funds to invest. When you get paid dividends from your shares, you can use this to pay down the home loan further.

This creates more funds available to invest and speeds up the process. Your total loan balance stays the same. Your home loan reduces. And your investment loan (the Line of Credit) increases.

Oh, and the interest on the investment loan is tax deductible of course. That’s the whole point in the first place, and why it must be kept separate from your main home loan.

After a number of years, the picture may look like this…

Overall Debt – $300,000

Home loan balance – $200,000

Line of Credit balance – $100,000

Available funds – $0

It’s important to note that your debt never goes down doing it this way. I know it sounds obvious, but some people wonder “but when will it be paid off”?

The answer is, it won’t. If your goal is to pay off the debt, then this probably isn’t the right type of loan for you. But if you’re happy to keep the debt for investment purposes, this might suit you well. More on that later.

Summary: Line of Credit is the most flexible option, but also the most expensive.

Debt Recycling with Interest Only Loans

Essentially, this is almost the same as above, with a few key differences.

Interest Only loans on Owner Occupied property usually come with a cheaper interest rate than a Line of Credit.

Some lenders such as UBank and State Custodians are offering Interest Only home loans for around 4%. Other lenders are a bit higher, but most still cheaper than Line of Credit loans.

With an Interest Only loan, it will only remain that way for 5 years. Then the loan will switch to Principal & Interest. So if you want to keep renewing the Interest Only period, you’ll need to keep refinancing. And that is no easy feat these days.

Banks used to roll over these loans as they expired, no worries. But these days, it requires full documentation and proving your income and expenses again, which seems to get more strict all the time.

So there’s no guarantees you’ll be able to keep getting Interest Only loans, unless you have a strong income, little other debt, and can prove to have low expenses.

Going this route, here’s how debt recycling would work for you…

Interest Only home loan balance – $300,000

Step one. Save up a decent lump of cash, say $20,000.

Step two. Pay down the loan to $280,000.

Step three. Apply to separate the $20,000 of equity from your existing home loan. This is called a split loan.

Step four. Withdraw the $20,000 to invest into dividend paying shares.

Again you’ll simply continue to pay your loan as normal, and now $20k of it is tax deductible.

As you build up more savings and collect dividends, you can pay down another chunk off your home loan. Then request to increase the size of your investment loan. And again use these funds to buy more shares.

Essentially, it’s the same process. This way it’s just done in lumps, rather than in one smooth facility like with a Line of Credit. The advantage with this option is a lower interest rate, which can save thousands per year.

You could repeat this process once a year.

After 5 years, your situation would look like this…

Interest Only home loan – $200,000

Investment loan – $100,000

And since 5 years are up, you’d need to refinance to get another Interest Only period. This way, your overall loan balance still stays the same, and you’re steadily converting your home loan debt to a tax deductible investment loan.

Summary: Interest Only loans aren’t quite as flexible as a Line of Credit. But the cheaper interest rate can easily make up for it.

Debt Recycling with Principal & Interest loans

Principal & Interest loans are what most people use. Where your repayments slowly chip away at the balance and eventually you become debt free.

This is by far the cheapest of all loan types. Currently, interest rates are as low as 3.6% from a number of lenders.

Sounds good, right? But can you do debt recycling with this type of loan? Yes, and here’s how…

Let’s take a home loan of – $300,000. And let’s say you’re unable to borrow more than this.

Well, like the above example, you can save up a lump of cash over the course of a year. Say $20,000. Rather than invest it, you could plow it all back into your home loan.

After a year, your loan balance would be around $280,000. Actually, it would be a bit lower because your regular loan repayments also help pay down the balance.

You’d then apply to access this $20,000+ of equity. And again, make sure it’s a ‘split loan’, separate from your home loan!

Now you invest those funds into dividend paying shares. Use the dividends and your savings to pay as much as you can into your home loan so you can do it again.

And when you’ve created another chunk of equity, simply re-apply to increase your investment loan. Just like in the Interest Only example earlier.

This will speed up the home loan payoff process, while allowing you to invest as well. After 5 years the outcome is the same as above…

Home loan balance – $200,000

Investment loan – $100,000

Whether you choose to have your investment loan as Principal & Interest, or Interest Only, doesn’t matter so much.

These loans are designed to pay down the debt. So your monthly loan repayments with Principal & Interest loans will higher. Maybe a lot higher.

But keep in mind, you can always access this equity again later by refinancing and pulling it back out to invest. That’s provided you qualify of course, which depends on bank lending criteria at the time.

Ideally, you don’t want to be paying down an investment loan since it’s tax deductible. You’d rather be using that cash for more investing, or paying down the regular home loan.

While it’s less than optimal, the lower interest rate can save you a ton of money.

Summary: Principal & Interest loans are easily the cheapest form of debt there is. But it means less flexibility in terms of cashflow, due to higher monthly repayments. Your debt will keep reducing unless you refinance every year to access the equity.

Maths Behind Debt Recycling

Hopefully you’re still with me!

Now let’s take a look at whether debt recycling is worth doing at all. I’ll use very simple numbers, because that’s how I roll.

Although some people might love it, I’m not busting out any spreadsheets to impress you with formulas and 17 different variables. Just some simple estimates will do just fine!

There’s only one reason to do debt recycling, or invest at all, rather than pay down your mortgage. And that’s whether you think you can earn a higher return by doing so.

Put simply, our investment return, after tax, needs to be higher than our mortgage rate. Otherwise, we’re wasting our time.

Here’s the wrong way to calculate the ‘debt used for investing’ equation…

My interest rate is 5%, and I’m on a tax rate of 40%, so my investment loan is really costing me 3%, because it’s tax deductible.

NO! This is so common it scares me.

First of all, you can’t just claim it on your tax return and get money back for nothing.

You first claim your interest cost against the investment income you generate by using that debt!

Then, if there’s a taxable loss, it can be used to offset other income and possibly result in a tax refund.

So if your interest rate is 5%, and you’re earning 5% dividend yield from your investments, your tax return is…wait for it…ZERO. Because your investment income is equal to your interest cost.

Hence, your total cost of debt is still 5%! If you don’t understand this, debt recycling is not for you.

Now we’ve got that out of the way, let’s see whether borrowing to invest stacks up…

Interest Cost vs Investing

So we need to earn a higher return after tax than our interest rate. Let’s use 4% as an average interest rate.

How does this stack up against what you’ll earn investing?

Personally, I’d feel fine banking on future returns from Aussie shares like this…

4% current dividend yield (plus 1.7% franking credit), plus 3% growth.

That’s a decent starting point I think. Certainly not overly optimistic. Historical returns have been higher. You can base your decisions on whatever return you wish.

On a cashflow basis, our return looks like this…

4% dividends, less 4% interest = 0% income. Plus franking credits of 1.7%.

Therefore, our taxable income is 1.7%. And if we were paying 37% tax, we’d be left with positive cashflow of 1.07%, which comes in the form of a franking credit tax refund.

So if we used $100,000 debt for investing, we’d have positive cashflow of $1,700 per year, or $1,070 after tax. If we add on our growth rate of 3%, our total profit margin is 4.07% above the interest cost. Round it down to 4%.

This juices our return by $4,000 for every $100,000 of debt we use for investing.

Compounding Effects of Leverage

It doesn’t sound like much does it?

Let’s see what it looks like over 10 years, with a higher amount of debt.

Say you have $400,000 of equity you can borrow to invest in shares. Using our simple numbers above, we will assume that $400,000 will earn a profit of 4%, above the cost of debt.

So it’s a simple equation. $400,000 invested for 10 years at a return of 4%.

The end balance is $592,000. As we can see, using leverage here generated an additional return of $192,000.

Now, some of you are probably screaming at me for being too simplistic. And I couldn’t agree more…

What About Interest Rates?

Here’s the spanner in the works. What if interest rates go up?

They sure do look more likely to go up than down, over the next decade. So inevitably, your return will likely be lower than this. And less reliable. And far more volatile.

The world doesn’t operate on a spreadsheet. That’s especially true in financial markets. They will be unforgiving for anyone not prepared, or banking on a smooth upwards trajectory. It just doesn’t work like that.

The best way to combat this unknown, is to simply factor in a higher interest rate. Rather than 4%, maybe use 5-6% and see how you go. The results are a lot less stellar!

This is why debt always makes your position less certain. If your cashflow isn’t great now, adding debt to the mix will kill you.

And there’s more to it than interest rates…

The Behavioural Impact

Now I know it’s easy for me to sit here and give you these numbers to compare. And debt recycling probably looks like a good idea for the most part.

But as we’ve seen recently, the market doesn’t always go up. And this can have a huge impact on our investing psychology. Sometimes we think the market is trying to tell us something. Maybe we’ve made a mistake?

Think about this before you jump into using debt for shares (even dividend investing)…

How will you feel if you have a pile of debt used for shares, and your portfolio drops by 20%? What about 40%? Or even 60%?

You might have an investment loan for $100,000. And your portfolio might have sunk to a value of $40,000. You’ll probably feel sick.

Will you want to sell? Probably. Just to stop the pain.

If anything, you want to be buying at the scariest times! But having debt, rather than excess cash, will likely prevent you from taking action.

Don’t underestimate the power of our psychology. Your brain will come up with all sorts of reasons why you should sell to avoid further losses. And we know that’s when it’ll be the worst possible time to sell.

Focusing on the dividends will definitely help. But remember, dividends may be cut if we’re in a recession, so no get-outta-jail-free card there.

It’s important to think about this stuff. Some places I see debt recycling mentioned, the people are off in spreadsheet land, where it’s all pixies and rainbows and the market goes up in a straight line.

Ultimately, the market doesn’t care about your expectations. Or whether your portfolio is deep in the red.

Other Things to Consider

I didn’t mention earlier, but you could even regularly increase your debt limit to invest further. That’s certainly an option, provided you have the income (and the stomach) for it.

But using debt for investing obviously adds more risk. Rather than pay down your debt, you’re keeping it the same, or increasing it.

If using a Line of Credit, this means a higher interest cost than normal. So it doesn’t take many interest rate increases to start killing your profit margin. Given this loan is costing you the most, it’ll be the most stressful to have in a market downturn.

Debt recycling also adds complexity. Rather than just invest and pay your mortgage, you’re having to manage an extra account, while you need to keep applying to access equity. That means more paperwork.

Another risk I see is…

It Can Kill Your Financial Independence

Let’s say you’re heading towards FI. You’ve been debt recycling and now your entire $400,000 home loan has been converted to an investment loan.

Your interest rate is 4%, and your dividend yield if 4%, or 5.7% including franking credits. So you’re making an extra 1.7% in cashflow each year, plus growth.

Remember, you’ll have to pay some tax on this profit, at your own tax rate. Your taxable profit is 1.7%.

But franking credits more than take care of that, because they count as tax already paid, so you’ll be entitled to a tax refund. Not bad. In practice, you’ll be cashflow neutral during the year, because your cash dividend (4%) equals your interest cost (4%).

Now let’s say that interest rates increase to 6%, over the next year or so. That will mean your position now changes to slightly negative cashflow. Your gross income is 5.7%, and your interest cost is 6%.

In practice, you’ll be out of pocket during the year, because your cash dividend (4%) is less than the interest cost (6%). But at tax time, you’ll get your entire franking credits refunded (1.7%). This means you’ll still be slightly out of pocket overall.

And who’s to say franking credit refunds won’t be axed in the next couple of years? If Labor wins the election, that’s their plan.

This will mean you’ll get no refund, and you’ll be out of pocket big time. If your interest cost is any higher than your dividend yield, then it starts to kill your cashflow.

Back to our example…

Our financial independence chaser had a loan worth $400,000 used entirely for dividend paying shares.

This cash generates a dividend yield of $16,000, plus franking credits. But his interest cost for the year is now $24,000.

He’s now in a position of negative cashflow, by $8,000 per year. And his franking credits are now not refundable, so they don’t help.

I don’t know about you, but $8,000 pays a lot of bills in my household. This can easily push back an early retirement date a number of years.

Maybe our friend decides to sell his portfolio to pay off the loan. But unfortunately, there’s no guarantee what mood the sharemarket will be in at that time. This means he’s at the mercy of the markets, or interest rates. Basically both!

I think this is a risky move. To risk delaying financial independence, or at least complicate it, for the sake of juicing a portfolio.

Sure there’s other options like working part time, or targeting higher yield shares and peer-to-peer lending to plug the cashflow gap. But these things maybe weren’t part of the initial grand plan for our early retiree.

Early retirement is the time to kick back and then focus on new adventures. Not for monitoring the economy and interest rates! Unless you’re a weirdo like me and find that stuff interesting!

Look, I get it. Who wants to have $400,000 of equity lazing around in a paid off house! But you’ll need to be pretty flexible to take an approach like that.

Margin Loans

I understand there are now some low rate margin loans around, such as NAB’s Equity Builder.

This can be a good option for renters who can’t access housing debt, and this particular margin loan has a similar setup to a home loan.

The same maths, concerns and trade-offs apply to this type of loan as well. Being a smaller group of borrowers, the bank can jack up the margin loan rate if they feel like it, and you can’t do much about it. Unlike home loan rates, where the banks know there will be huge public backlash if they do that.

While the low rate margin loan is a very positive development, make sure it’s right for you before diving in.

What I’m Doing and Why

You probably can’t tell whether I’m for or against debt recycling at this stage!

Our situation is a lot different for a number of reasons. We’re now in the FI stage for one thing. Our earnings from dividends and part time work is still low, relative to our debt.

Overall, we’re still equity rich, cashflow poor. But that’s improving on a regular basis as we continue to buy shares and slowly sell off properties.

This means we’re unable to ask the banks for anything! Not until that situation vastly improves.

Anyway, we sell a property and get a big lump of cash. Some of that cash has to stay in the bank to cover expenses. But the rest can be invested.

We’re renting, but we have some small non-deductible loans that were used as deposits on properties we no longer own. So with a lump of cash, we recently paid off one of these loans, then redrew the money back out and bought shares with it. Now that loan is deductible against our dividend income.

The money was going to shares anyway. By doing this, it simply stops off at the bank to pay off a loan, before it goes to its final destination. We’re not really going to any effort to do it.

We may repeat this process again in the future. But for the most part, we’re simply investing cash on a regular basis. Debt recycling is a secondary consideration to our overall goal, which is building investment cashflow.

Would I do debt recycling if I started again?

To be honest, I probably would. Personally, I’m quite comfortable with taking on more risk, within reason, in pursuit of a higher return. Or just to optimise things as much as possible.

But having already complicated the shit out of our finances, I’m not sure it’s the no-brainer some people think it is.

The philosophy of keeping it simple grows on me every day. And I think it’s only after you complicate things, that you realise how wonderful simplicity is.

Paying off the minimum on your home loan, while investing as much as possible is the core strategy. By ignoring all the possible optimisations, you’ll still do perfectly fine, and you might even enjoy it more!

The optimiser crowd is famous for agonising over the best strategy, or the best tax outcome etc. When all that really matters is finding a common sense, repeatable plan and sticking with it.

Summary

The debt recycling decision is harder now, with the changes in the banking landscape over recent years. Not like when borrowing was easier, loans more flexible and there was little difference in interest rates between products.

Over the long term, returns from shares are still likely to be higher than mortgage rates. But clearly, there’s a lot more to it than that, before you assume debt recycling is the right way to go.

It really comes back to you and your goals. And how you feel about risk, complexity and debt. So do I think it’s worth it?

Well, if you’re happy to keep debt around and use it for investing, then it’s probably worth considering. Just keep the risks in mind and imagine how different scenarios could play out, and how you might react in those situations.

But if you were aiming to be debt free at some stage, I probably wouldn’t bother with it. And for some people, there’s no equation attractive enough for them to feel good about debt recycling. That’s perfectly okay.

Overall, as long as you maintain a high savings rate, and invest for a strong and growing income stream, you’ll become financially independent faster than most… debt recycling or not!

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Note: Keep in mind, I’m not an expert in loans or tax! There’s an infinite number of ways to organise your loans to do debt recycling, these are just a few examples. Please consider your own circumstances carefully before starting a plan like this, and as always, do your own research.