Traditionally, individuals wait until their home loans are fully repaid before venturing into wealth creation. However, as home loans continue to grow and retirement ages decrease, this conventional approach limits the growth potential of investments. The concept of debt recycling challenges these traditional strategies by initiating the wealth creation process immediately.
What is Debt Recycling?
Debt recycling involves paying down a home mortgage and subsequently borrowing similar levels of funds to invest in income-producing assets, such as shares, businesses, or property. The aim is to use the income generated from these investments and associated tax benefits to expedite the repayment of non-deductible debt, ultimately making money work harder in the long term. Instead of waiting to invest after the home loan is repaid, debt recycling enables individuals to start investing now while continuing to service their mortgage, leveraging existing debts to potentially generate long-term wealth.
By recycling your debt in this way, you can benefit from potential tax advantages while simultaneously working to reduce your home loan faster. It's a strategy that aims to make your money work harder for you in the long term.
How Debt Recycling Works
There are a few ways to transition ‘non-deductible’ debt to ‘deductible debt’ – but it is crucial you set this up correctly from the beginning, which is why we always recommend getting professional advice. You may be able to use an existing share portfolio or savings to pay down an existing non-deductible loan (generally on your primary residence), and then using your equity, borrow funds for a similar amount to purchase an ‘income producing asset.’ This investment loan is generally tax-deductible, and the income generated is used to pay off the non-deductible home loan, facilitating a continuous cycle.
Historically, barriers have been the ease or arranging this with a bank, keeping everything separate, and managing this process. Fortunately, with the Lending and Financial Services teams at Prosperity, the process is streamlined. Debt recycling works incredibly well during a refinance and is suitable for many people, particularly those aged between 35-50 with steady incomes who want to get ahead and reduce their mortgage.
The following hypothetical situation outlines the real-world application of debt recycling. James and Sarah are a Brisbane GP couple in their 40s both earning approximately $250K p/a with a $1.2M mortgage and $150K share portfolio. By selling their share portfolio (be mindful of capital gains), refinancing their loan, utilising equity releases, and strategically repurchasing shares, depending on the strategy utilised over 10 years, they could see a net benefit of up to $212,000 in year 10 and pay off their mortgage one to two years faster all with a similar debt level.
Assessing the Risks and Benefits
Debt recycling is a strategy that contains different risk levels. If you were to pay down your loan with an existing share portfolio and then borrow to purchase similar shares, theoretically, there would be no increased risk. If you use cash to debt recycle, then your risk levels should be no higher than using cash to purchase shares in the traditional sense, if set up correctly. Should you borrow more than your original loan amount, then this would classed as a ‘geared investment’ and would be higher risk. However, the potential benefits include tax savings, diversified investment portfolios, and accelerating your home loan repayment schedule. When executed correctly, individuals can own their homes sooner, save on taxes, and build a diversified investment portfolio.
Risks:
- Investment Risk: The chance that investments may underperform, impacting financial goals.
- Interest Rate Risk: Dependency on low-interest borrowing, with an increase in rates affecting gains and increasing debt burden.
- Cash Flow Risk: The importance of maintaining sufficient cash flow to cover debt-related costs.
- Discipline and Willpower: The need for discipline in allocating investment income and tax savings to loan repayment.
- Insurance Review: A thorough review of insurance coverage to protect against unforeseen events.
Benefits:
- Tax Advantages: Conversion of non-deductible debt into deductible debt for tax savings.
- Diversified Investments: Spreading investments across different assets minimises risk.
- Faster Home Loan Repayment: Utilising home equity accelerates repayment for financial flexibility.
- Compounding Returns: Early wealth building through debt recycling allows for compounding returns.
- Tax Efficiency for High Earners: High-income earners can find debt recycling cost-effective, optimising tax benefits.
While debt recycling provides tax advantages through deductible debt, individuals must also consider potential implications such as capital gains tax. Understanding the tax implications is crucial to making informed decisions and maximizing the benefits of the strategy.
Is Debt Recycling Worth It?
Debt recycling is a dynamic approach to wealth creation, challenging traditional financial planning norms. While it comes with inherent risks, the potential benefits, including tax savings and accelerated home loan repayment, make it a compelling strategy for those with a long-term focus, stable income, and risk tolerance. The decision to pursue debt recycling depends on individual financial situations and goals. As with any financial strategy, seeking professional advice is paramount to ensuring the best outcomes and minimising potential pitfalls.
A complex strategy like debt recycling can be made extremely simple when your financial adviser, lending specialist and accountant are all on the same page. At Prosperity Advisers, we provide tax/structuring advice, financial advice and lending advice by professionals who are specialists in this area. We recommend you reach out for advice before implementing, to ensure this is the right strategy for you, and we will help you from start to finish.
For more information, please contact Business Services & Taxation Director Brendan Campbell at bcambpell@prosperity.com.au, Financial Adviser Rocky Johnston at rjohnston@prosperity.com.au or your Principal Adviser.
This article contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information. Prosperity Wealth Advisers (ABN 32 141 396 376) is an authorised representative of Prosperity Wealth Advisory Services Pty Ltd, Australian Financial Services Licensee (533675).