Debt recycling is a strategy that's commonly used to build wealth while avoiding income tax. It works by taking out equity locked in owner-occupied property and investing it elsewhere with the intent of generating a passive income.
Proponents of debt recycling see two types of debt: 'Bad' debt and 'good' debt.
- Bad debt: Costs money but doesn’t lead to earnings (an owner-occupier home loan, for instance)
- Good debt: Used to purchase assets that generate income, and interest is often tax-deductible
The aim of debt recycling is typically to pay off your home loan as quickly as possible while also borrowing against home equity to buy assets that can provide a passive income.
How does debt recycling work?
Debt recycling works by essentially borrowing against the equity in your home and using those borrowed funds to invest it in income-producing assets that have the potential to grow in value. These could be things like an investment property, shares or ETFs.
Here are the steps one might take if they're recycling debt:
- Use spare cash to make a lump sum repayment on a home loan, thereby building equity
- Go to their lender and redraw funds or take out a new loan using home equity as security
- Use the money borrowed under the new loan or redrawn funds to buy investment assets, like property or shares
- Claim the interest paid on the redrawn funds or investment loan as a tax deduction
- Optional: Use the income produced by investments to repay their home loan faster
Typically, the interest on loans used for investment purposes is tax deductible, unlike interest on owner-occupier mortgages. So, by effectively transforming mortgage debt into investment debt, proponents of debt recycling aim to create a tax saving. In addition, they likely expect to be building their wealth at the same time by buying appreciating assets.
In theory, this can create a sustainable cycle. Though it relies on investment performance and careful financial management.
Pros of debt recycling
The benefits of debt recycling largely relate to the ability to borrow money used to invest and deduct interest costs. Doing so can:
Generate magnified compounding gains which may be used to pay off your original loan sooner and save on interest costs
Allow you to diversify your portfolio into multiple investments
Earn you a passive income
Cons of debt recycling
However, the major drawback is increased risk. Investing is always risky and, with the typical exception of term deposits and bonds, no investment is guaranteed to provide a return and may even result in a loss.
By securing investment loans against your home, you risk your lender repossessing your home in the event you can't meet your repayments on your other debt.
Other risks include:
Potential of magnified losses during market downturn
Potentially higher interest rates on loans used for investments
Variable rates change over time. If your loan isn’t on a fixed-rate when interest rates rise, you will have to pay more interest
You may need access to the money invested in prospects in the near future
What is equity?
Your equity in a home is the value of the property minus how much you owe on the mortgage tied to it. It's the portion of your home's worth you actually own.
Helpful tool: Equity calculator
Example: Augustine buys a house for $500,000 with a 20% deposit ($100,000 of her own savings) and a $400,000 home loan. Her equity in the property at this point is $100,000.
Over 10 years, she pays $150,000 off the home loan’s principal (leaving $250,000 owing) and the property’s value increases to $550,000. Augustine’s equity in the house is now $300,000 ($550,000 minus $250,000).
How to access equity for debt recycling?
Refinancing
One of the most common methods of accessing home equity is by refinancing the mortgage. When you refinance, you leave your current mortgage and switch to a new mortgage.
When you refinance, your property can also be revalued. Revaluing your property may show your home has gone up in value, meaning you can access more equity.
When digging into your equity, it’s important to note you’ll still have to pay it back eventually. You’re basically taking away from the principal amount you’d paid off, so you’ll end up paying it back plus interest over time.
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Redraw facility
If your mortgage has a redraw facility, this is another potential way to access some of the equity in your home.
When you make extra repayments towards your home loan, they go solely towards the principal loan amount, a therefore helping you build equity. If you have made enough additional contributions, you could potentially have a stack of money available for you to redraw from.
Other ways to access equity
There are plenty of other ways to access your home equity if you're planning to debt recycle.
You might consider a line of credit home loan, which essentially allows you to increase and decrease the size of your debt at whim, a reverse mortgage, or taking out an entirely new loan secured against your equity.
Savings.com.au’s two cents
Debt recycling may be a concept you are considering in order to pay off your mortgage quicker than with your scheduled repayments. Before you do, we recommend speaking to an expert or financial adviser.
Having considerable equity reinvested puts you at risk to changes in the market. Without a safety net and steady income, you could put yourself in considerable financial risk. On the flip side, if you have the financial security, debt recycling could potentially speed up the payment of your mortgage and your overall wealth growth.