Finance 101: everything you need to know about debt recycling

Summary

Explore the concept of debt recycling, a strategy that involves converting non-deductible debt into deductible debt to build financial wealth. This guide covers how debt recycling works, its potential tax benefits and the associated risks, helping you determine if it aligns with your financial goals. 

What is debt recycling?

Debt recycling is a wealth-building strategy where you trade (recycle) a non-deductible debt for a deductible one, while also building your wealth in a tax effective way. Let's break it down simply:

1. Start with debt: You have a non-deductible debt, usually a home loan, which you need to pay off.

2. Swap the debt: You use some of the value in your home – your equity – to take on a different kind of debt, this time for investments that might grow over time.

3. Earn and pay: These investments could make money, which you can use to pay off your home loan faster.

4. Repeat the cycle: As you pay off your home loan, you take out more investment debt and keep the cycle going, aiming to eventually replace your home loan entirely with investment debt.

How does debt recycling your home loan work?

The strategy taps into the equity in your home to invest in income-producing assets that have the potential to grow. Over time, the returns from these investments can be channelled toward your home loan, helping you pay it off faster than sticking to regular payments alone.

Why should I care about debt recycling?

One key advantage of debt recycling is that the interest on investment loans is typically tax deductible. This means debt recycling could lead to tax savings, which you can then use to further reduce your home loan, which ordinarily is not tax-deductible. Plus, if your investments appreciate, you’re simultaneously boosting your wealth.

What are the financial risks?

Debt recycling is considered high-risk because it involves borrowing to invest, using your home as collateral. Poor investment performance or rising interest rates could lead to significant financial stress, potentially jeopardising your family home. Here are some important considerations:

• Market volatility: Borrowing money to invest can lead to bigger gains when markets are rising. However, when markets are falling, your losses will be larger as you still have to pay interest and repay the loan.

• Variable rates: If the interest rate on your loan isn’t fixed, a rise in interest rates can lead to your repayments increasing. This can put pressure on your cash flow, which can be compounded further if the income from your investments is lower than expected.

• Depreciation: Assets bought with borrowed funds can fall in value. This means that even if you receive tax deductions from the investment over time, it can still fall in value, and you can still be in debt even when you sell the asset.

• Focus your spending: It takes willpower and discipline to use the investment income and tax savings for your home loan each year, instead of spending it on a ‘want’ like a holiday, or new car.

• Unexpected life changes: If you decide to pursue this strategy, it’s worth reviewing your insurance cover to ensure the extra loan can be repaid in the event something happens to you, like illness, injury or even death.

Debt recycling checklist

For a debt recycling strategy to work, you need:

• A home loan, with equity in your home

• A regular income that is generated independently of this debt recycling strategy. This income can deliver a surplus cash flow to cover the interest payments on your investment loan

• A long-term investment focus

• A willingness to increase your debt and hold an investment loan

• High tolerance for risk and short-term fluctuations in investment value

• To consider income protection insurance, which may provide replacement income in case you’re sick or injured and unable to work.

Considering debt recycling?

Remember, debt recycling isn't for everyone. It’s essential to fully understand the risks involved and if it suits your personal circumstances. Consulting with a financial adviser can help determine if this strategy aligns with your financial goals.