Last updated: July 2021. Original post: 2018.
Debt recycling gets talked about as a tax effective strategy. But it’s rarely broken down in plain English how it works in practice.
In this article, I’ll explain how debt recycling works, when it’s a good idea and some things I see missing from the conversation.
Hopefully, by the end of it, you’ll have a good idea whether debt recycling feels right for you. There’s a lot to discuss, so let’s get started!
What is debt recycling?
Debt recycling is a strategy which aims to turn your current non-deductible home loan into a tax-deductible investment loan.
This involves paying down your mortgage and re-borrowing that money to invest with – hence the ‘recycling’.
In this way, you end up with a higher return on your investment. That’s because you are taxed less as you now have a tax deduction you wouldn’t have before.
But as I’ll explain, it’s different from using leverage and increasing your debt to invest.
Debt recycling can be very effective, but there’s a few things to understand first and it’s crucial this strategy is implemented properly.
How does debt recycling work?
Generally, you take money you were going to invest and pay down your home loan instead. You then pull that money back out and invest it. In doing so, you make that portion of the loan tax deductible.
As you keep paying extra off your home loan, you continue to redraw that money to invest into income producing assets like shares.
You can use the investment income, regular savings and tax savings to pay down your non-deductible home loan even faster to speed up this process.
Here’s one example of how it looks using a line of credit…
(Courtesy of Peter Thornhill)
When you recycle debt, the non-deductible mortgage gets smaller, while the investment loan generally gets bigger. Eventually you’re left with just a tax-deductible investment loan.
At this point, you can choose whether to also pay off the investment loan or not.
A word of warning.
Sometimes debt recycling is spoken about like a magic way to pay off your home loan, save tax and build wealth at the same time. While that can be true, it’s not for everyone.
First, it’s a bit more complex than simply investing and paying down your loan as normal. Second, you need to already be relatively good at managing money and your accounts.
Saving remains the key to building wealth. Debt recycling can be seen as tinkering around the edges.
Having said that, it is pretty cool! Here’s a proper example with numbers…
How to do debt recycling, in practice.
If you’ve decided you want to invest rather than get rid of your debt, here’s why you might consider this.
Debt recycling is more tax efficient than simply investing the same amount of money. You are saving the tax you would have paid on the income from your investment, without cycling it through a loan first.
Here’s an example…
1. You have a home worth $500k with a $300k loan. You also have $100k in your offset account.
2. You can split your home loan into two, so that you have $200k loan and $100k loan.
3. You pay off the $100k loan with your offset money. Then you pull it back out, sending it straight to your brokerage account (if buying shares).
4. Interest on the $100k loan is now tax deductible, provided you invest in an income-producing asset.
Tip: you may wish to pay down your loan balance to $1 rather than zero in case it gets closed. Best to check with your lender to see if they will leave the loan facility open with a zero balance.
The numbers behind debt recycling.
Okay, here’s how it works using nice round numbers for simplicity using the steps above. You have a $300k home loan with a 3% interest rate, and $100k in cash.
Option A: Investing without debt recycling:
Invest $100k. Receive $4k of income. If tax takes 50%, you’re left with $2k income.
Option B: Investing with debt recycling:
Pay down $100k of debt (your non-deductible home loan). Redraw $100k and invest it. Receive $4k of income.
This time you can claim $3k of interest as a tax deduction (interest on $100k). You now pay tax on $1k of investment income, which is $500.
Okay, let’s recap…
With both options you have $300k of debt. You’ve paid the same amount of interest, and you have invested $100k.
But by debt recycling, you’ve saved $1500 in tax that year compared to if you didn’t.
An important note about tax…
You can only claim interest expenses if the debt has been used to produce income.
Here’s the ATO’s statement regarding ‘dividend and share income expenses’:
“You can claim a deduction for interest charged on money borrowed to buy shares and other related investments that you derive assessable interest or dividend income from.”
“Only interest expenses incurred for an income-producing purpose are deductible.”
What’s the outcome of debt recycling?
You have more cash each year after tax than if you simply invested and paid down your mortgage normally.
You can use this extra money to pay down your non-deductible mortgage further or increase your investments. In this way, debt recycling can actually help you pay down your home loan faster.
As time goes on, the tax savings increase as your portfolio gets bigger and your home loan reduces compared to your investment loan.
Debt recycling is using debt to invest with. But you are not increasing your debt. You are ‘recycling’ your current debt into a new purpose.
To be clear, if your loans are interest-only, your debt remains the same. If you’re paying P&I, your loan balance will continue to reduce over time.
Now, there’s two main ways to implement this strategy. The first one we’ll call debt recycling in chunks.
Debt recycling in chunks.
This is probably the most common method and what we’ve described so far.
You save up a lump of money, pay down a chunk of your mortgage, and then re-borrow and invest those funds. Then it’s a case of saving up another lump of cash and repeating the process.
The reason you typically do it in chunks is because banks have a minimum loan split you are allowed to create, such as $20,000 for example.
But there is a way to debt recycle and invest in shares on a monthly basis.
Monthly debt recycling
With this method, you use some equity in your home to create a separate loan split. You pull this equity out and put it into a new offset account which you attach to your new loan split.
As you save each month, instead of investing, you pay down your main home loan. You then pull the same amount out of your new offset account attached to your new loan and send this straight to your brokerage account to buy shares.
The interest on the new loan is tax deductible because you’ve used that money for investing. This lets you dollar cost average into shares rather than investing big lumps, which is more enjoyable and less stressful.
If you don’t have enough equity in your home for this, you could also set up a loan split now for say $20k with your current loan. Pay it down with your savings each month.
Once it’s paid down, each month you can take out the amount you want to invest, while you create another split to start paying down with your regular savings to repeat the process.
What type of loan do I need?
This has been a common question. There’s no special loan for debt recycling.
It can be a normal plain vanilla home loan. But you do need the ability to create splits and redraw, which many have. An offset account may be helpful too for the above approach.
Many home loans can be split into smaller portions. Just check with your bank whether it can be done. Think of how common it is to split a loan between fixed and variable rates – it’s basically the same setup.
You don’t need to end up with 10 small split loans either. You can request to have your main home loan limit decreased, and your investment loan increased. This makes things more organised, but it does depend on how flexible the lender is!
Is debt recycling legal?
Yes, it is definitely legal. Some people think the ATO will come after them if they’re utilising this strategy. But that certainly doesn’t seem to be the case.
The ATO have fielded questions on debt recycling on their community forum – here – and have not suggested they have an issue with this approach.
Yes, this is a tax-efficient way to invest. But it’s hardly some type of elaborate tax avoidance scheme.
Remember, you are earning higher net returns than you would otherwise by structuring it efficiently. And you’re actually paying more tax by investing than if you simply paid down your home loan.
You aren’t stacking up a bunch of bogus tax deductions for the sake of it (interstate travel to ‘manage’ investment properties?).
If you’re not convinced you can always reach out to them with details of what you plan to do and see what they say.
Principal-and-interest or interest-only loans?
You can debt recycle using both types of loans. When setting this up, your main home loan is probably a principal-and-interest loan.
For debt recycling, it’s more effective to use interest-only loans. This means your repayments will be lower and you can divert more cash towards paying down your non-deductible mortgage even faster.
Having said that, these days switching part of your loan to interest-only may require an assessment of your borrowing capacity once again.
You could also use a Line of Credit home loan too, but interest rates are even less attractive again, so I probably wouldn’t bother with that.
As mentioned, you may want to get a new offset account to attach to your loan split. This helps you avoid any sort of contamination between your personal funds and money for investment.
If you can transfer loan proceeds from the loan account straight to your brokerage account, there’s no real need for the offset. But some loans don’t have that functionality and you can only move the funds into a transaction account first before sending it elsewhere.
Moving loan proceeds into your everyday account and then to your brokerage account to invest would then contaminate those funds. Keep the loan split and the offset funds completely separate from your main loan and offset account. Don’t mix the money!
It also helps if you have a lender which doesn’t make things difficult. And from what I’ve heard, not all lenders are the same when it comes to flexibility with your loans.
As you can tell, there’s a lot of ins and outs to debt recycling. If any of this is unclear (or even if it is) then it might be best to see a trusted tax expert to ensure you’re implementing this strategy the right way.
It’s probably also a good idea to get help setting up your loans correctly, so perhaps see a mortgage broker who knows what they’re doing (recommendation below).
Debt recycling is not for everyone. Most people like to keep things simple, with their home and investment activities completely separate. And if you just want to get rid of your mortgage ASAP then just focus on that.
But for those who don’t mind taking on some extra work and complexity, debt recycling can definitely be a profitable and tax effective strategy, helping you pay down your mortgage faster while building investments at the same time.
Thanks for reading!
Here are some resources you may find useful on your wealth building journey:
Sharesight: A great portfolio tracking tool for share investors, and free for up to 10 holdings. It tracks all dividends, franking credits and capital gains, which is incredibly helpful at tax time. Saves me a lot of time and headache!
Mortgage broker: My personal broker of 10 years is More Than Mortgages. Highly rated and award winning, Deanna and her team been super helpful over the years and can assist with anything home loan related, including refinancing and debt recycling.
My book: After 5 years and hundreds of articles and podcasts, I decided to distill everything down into an easy to follow book. Designed as a complete roadmap to achieving financial independence and retiring early in Australia. Available in paperback, ebook, and audio.
Just so you know, if you choose to use these resources, this blog may receive a financial benefit at no extra cost to you. Thanks in advance if you do. And to be clear, I only ever recommend things I use myself and genuinely believe in 🙂