Debt recycling is often praised as a tax-efficient strategy, but it’s not always explained in plain language. Let’s walk through what it really is, how it works, and whether it could be a good fit for you. By the end, you’ll have a clear understanding of how debt recycling can help you pay off your mortgage faster and build your wealth at the same time.
Before you read on, let’s get the disclaimer out of the way. I’m a mortgage broker, not a taxation advisor. I’m not licenced to give taxation advice. The below is based on my 15 years’ experience in the mortgage broking industry. So please speak to your accountant or financial advisor before making any decisions.
Turning Your Mortgage Into an Investment Tool
Debt recycling is a clever way to transform your non-deductible home loan (which doesn’t give you any tax breaks) into a tax-deductible investment loan. Essentially, you pay down your mortgage, then re-borrow that same amount to invest in income-generating assets, like shares or property.
So, instead of paying off your home loan and leaving it at that, you’re “recycling” the debt into something that could potentially give you tax benefits. The result? You pay less tax and increase your potential returns, which in turn will give you more money to use to pay off your non-deductible home loan.
How It Works in Practice
Instead of putting your savings straight into investments, you use that money to pay down your home loan first. Then, you redraw the same amount and invest it. By doing this, you make part of your loan tax-deductible.
As you continue paying down your home loan and redrawing to invest, your non-deductible mortgage shrinks while your *investment loan grows. Over time, you’ll end up with a loan that’s entirely for investment purposes—and fully tax-deductible. At that point, you can decide whether to keep the loan or pay it off.
*It’s important to note that you need to use a lender with a specific loan product to do this. You can’t simply redraw directly out of a non-deductible loan for investment purposes, otherwise you’re “tainting the loan” i.e. part of the loan was used to buy your home (non deductible) and part was used for an income producing investment (tax deductible). Instead, you’ll need to split your home loan. Here’s an example.
A Simple Example to Break It Down
Let’s say you own a home worth $500,000 with a $300,000 home loan. You also have $100,000 saved in an offset account.
To start debt recycling, you split your home loan into two parts: one for $200,000 and another for $100,000. You then use your $100,000 savings to *completely pay off the second loan, then redraw that $100,000 to invest. Now, the interest on that $100,000 loan is tax-deductible because you’re using it for (income producing) investments.
*Ask your lender or broker if you can pay off a home loan to $0. Some lenders will automatically close the loan (which you don’t want!), so you may have to leave $10 owing, before redrawing for investment.
Why Debt Recycling Can Be a Game-Changer
The beauty of debt recycling is that it can help boost your returns without taking on additional risk. By converting part of your mortgage into an investment loan, you lower your taxable income, leaving you with more cash in hand. You can use this extra cash to either pay down your mortgage faster or reinvest it to grow your wealth even more.
And with higher interest rates, the tax savings can become even more significant. If you’re in a higher tax bracket, the benefits are even bigger.
Things to Keep in Mind Before You Dive In
Debt recycling isn’t for everyone. It’s a bit more complex than simply paying off your loan and investing separately, so you need to be comfortable with managing your finances. If you’re already good at budgeting and keeping track of your investments, this strategy could be a great fit. But if simplicity is more your style, focusing on paying off your mortgage might make more sense.
Another thing to remember: this strategy only works with investments that generate income, like shares (paying dividends) or investment properties. You can’t claim a tax deduction if the investment doesn’t give you any income, so make sure you’re investing in the right assets.
How to Get Started with Debt Recycling
If you think debt recycling could work for you, here’s how to get started:
- Split your home loan, so you now have 2 loans.
- Use your savings or investment funds to pay down the 2nd loan to $0 owing.
- Redraw out of the 2nd loan and invest it in an income-producing asset, like shares or property.
- Keep repeating this process until your non-deductible debt is gone, and your investment loan is fully tax-deductible.
What Type of Loan is Best for Debt Recycling?
It’s important to structure your loans correctly. The majority of lenders do NOT allow “rebalancing” of loans easily (increasing the investment loan, while at the same time decreasing your home loan by the same amount). Most lenders will require a full assessment (basically a new home loan application, which will take 4 weeks and a mountain of paperwork).
You’ll need a lender that allows splitting of loans and rebalancing without a full assessment, minimal paperwork and be able to be done quickly (days, as opposed to weeks).
Having offset accounts can also be useful for this strategy.
Yes, It’s Legal!
Debt recycling is 100% legal. The Australian Taxation Office (ATO) allows tax deductions on interest for loans used to buy income-producing assets like shares or rental properties. As long as the loan is for an income-generating purpose, the interest is deductible.
The ATO has even addressed debt recycling in its forums, confirming that it’s a legitimate strategy. However, it’s always a good idea to speak with a tax expert to make sure you’re doing it correctly and getting all the benefits.
Wrapping It Up
Debt recycling is a smart way to pay off your home loan faster while growing your investment portfolio and saving on taxes. But it’s not for everyone. If you’re confident in managing your money and investments, it can be a powerful tool to boost your wealth. But if you like to keep things simple, sticking to a traditional mortgage repayment plan might be the way to go.
Before jumping in, it’s important to consult with a tax advisor and/or a financial advisor. It’s also important to a give us a call on 02 6188 4555 or make an appointment to discuss your options and help you set everything up properly. Done right, debt recycling can help you reach your financial goals faster—saving on taxes while building wealth along the way.
If you’d like an even more detailed read on debt recycling, check out this article that Dave Gow wrote on his Strong Money website. Dave’s a client of mine!
