Debt recycling is a financial strategy that is designed to help pay off your home loan sooner, while also building wealth in a tax-effective manner over the longer term. It involves replacing or, recycling, ‘bad’ debt with tax-deductible ‘good’ debt from investments.

Good debt or bad debt?

What is ‘good debt’ and ‘bad debt’? What does it mean?

Put simply, good debt is debt you take on for investment purposes. You are aiming to grow these investments over time, and the interest rate charged on the good debt is generally tax-deductible. This means there is a tax-advantage with this debt as the interest costs can reduce the amount of tax you pay.

On the other hand, ‘bad debt’ is debt for which there are no tax advantages. The interest payments are made with your after-tax income. Common examples of bad debt are credit cards and car loans.

There is one other form of debt, and it is generally the most common form: mortgage debt over your home. While strictly speaking, mortgage debt is ‘bad debt’, because you do not receive tax advantages for the debt, it is also beneficial as it allows you to purchase an asset (i.e. your home) that is expected to grow over time.

How it works

We all know the value of making additional home loan repayments. Additional loan repayments reduce the loan and can save interest costs in the long run. Essentially, what you are doing is reducing the level of bad debt you hold.

As you reduce the bad debt you could replace it (i.e. recycle) with good debt.

For example, as you pay down your home loan you are creating equity in your home because the portion of the home you own is increasing, while the value the bank owns (i.e. your mortgage) is decreasing.

As your equity position increases you could consider drawing on this equity for investment purposes.

What are the benefits of debt recycling?

Benefits of debt recycling can include:

• You are able to invest sooner. Rather than waiting to repay your home loan and then invest, you can progressively draw on the equity in your home for investment purposes. This allows the power of compounding earnings to start working sooner.
• You could pay down your home loan much sooner by using the earnings on the investments to make additional home loan repayments.
• Interest costs on the investment loan are generally tax deductible, meaning you pay less tax.

What are the risks to consider?

• Debt recycling involves the use of debt to grow wealth. As a result, there are a number of risks to consider before undertaking this strategy:
• If investment markets experience a downturn then debt recycling can lead to compounding losses.
• Interest rates charged on investment loans are often higher than the standard variable mortgage rate.
• You need to consider a long-term investment timeframe with this strategy. Debt recycling is not recommended for anyone with an investment timeframe of less than five years.
• You should not be reliant on the investment earnings to repay the loan or fund your lifestyle. You need to ensure you have a steady and reliable income source, like ongoing employment, to ensure you have the means to repay the loan.
• You should ensure you have adequate insurance in place to help meet loan repayments if your income stops because of death or illness.

If you are interested in discussing a debt recycling strategy with a financial adviser, please contact us.