Debt recycling is a bit of lightning rod in the Financial Independence (FI) community. Some folks swear by it as a tax-efficient way to grow your investment portfolio, while others think it’s a headache best avoided. But no matter where you stand, one thing’s clear: if you’re diving into debt recycling, you need to know what you’re doing.

In this Aussie FIRE episode, we dive deep into the mechanics of debt recycling – how it works, why it appeals to some folks, and the key factors to weigh before you jump in. Like any investing strategy, it’s not without risks. It has nuances and small details that might not be obvious at first glance. That’s why it’s worth having a chat with a professional who understands this strategy inside out and how it might work in your unique situation.

What is debt recycling, and how does it work?

Debt recycling doesn't really scream "simple" when you first hear it. But essentially, debt recycling is about turning your regular, non-tax-deductible home loan into a tax-deductible investment loan. Now, of course, what follows is just a high-level overview. There are some details to iron out and steps to follow to make sure it’s done correctly.

Here’s how debt recycling might work in practice

Imagine you have some money that you want to invest. Instead of investing it straight away, you first cycle that money through your home loan. Put another way, you use it to pay down a portion of your mortgage.

Once you've done that, you then redraw that same amount from your home loan and invest it in income-producing assets. It could be shares or Exchange-traded Funds (ETFs) , but it doesn’t have to be – property works too.

When you do this, the portion of the loan used to invest becomes tax deductible. Reason being, you’re using some of that loan to earn income, rather than for personal expenses. Hence, according to the ATO rules, you may be able to deduct the interest cost on that investment income. If so, this could effectively lower your taxable income, meaning you might end up paying less tax overall.

Another benefit is you can use that investment income and those tax savings (plus any regular savings you might have) to pay down your non-deductible loan more quickly. As you make progress, you have the option to borrow again and reinvest – if it still aligns with your goals at that point.

This brings us to an important thought: debt recycling isn’t something to consider in isolation. It ultimately comes down to where you want to place your focus. Would you rather concentrate on paying off your mortgage as quickly as possible? Or do you want to prioritise building an investment portfolio? These are two different strategies that lead to different outcomes. But if you want to do both at the same time, even if it might take a bit longer, then debt recycling might be a strategy worth considering.

Here’s a hypothetical example of debt recycling with numbers…

With that perspective, let’s look at a practical example. Let’s assume you own a $600,000 property with a $400,000 loan attached. You’ve been diligent with your savings and have $100,000 sitting in your offset account.

At this point, you could approach your lender and request to split your home loan into two separate loans – say, a $300,000 loan and a $100,000 loan. Notice that your total debt stays the same, just divided differently. With that split, you can take the $100,000 from your offset account and pay down the smaller loan to zero. Then, we redraw that amount to invest in shares, assuming that’s the investment strategy you have chosen.

What happens is that the interest on that $100,000 loan becomes tax-deductible. The ATO stipulates that for interest to be tax-deductible, it must relate to an asset that produces taxable income. And most shares and ETFs generally tick that box (make sure to check this first with your broker or on the fund’s website).

From here, the process sort of snowballs. As you receive dividends and continue to save, you’re not only reducing your tax payable due to the deductions on the interest. You're also potentially using those savings to pay down your home loan faster. Once you’ve reduced your home loan by a decent chunk, you might consider doing another round of debt recycling and repeating the process.

But there’s a small detail you need to be aware of: some banks will close a loan account if it’s fully paid down to zero. So, before you rush ahead, it’s worth chatting with your lender to see whether they’d keep the loan facility open or not. And if they’re the type that closes it, you might leave a small balance that satisfies their requirements. That way, the account stays open and you can redraw funds again if needed.

To be clear, though, debt recycling is not for everyone. This strategy still involves taking on debt in the first place. And any ideal outcomes we’re discussing here hinge entirely on your ability to make payments on time. It’s definitely not a strategy to dive into without carefully assessing your financial situation or consulting with a professional first.

But how is it deductible if the debt is still attached to a personal home?

You’re probably wondering: "If the loan is tied to my personal home, how can it be deductible?”. And the answer is that, from Dave’s experience, it’s about what the debt is actually doing, rather than what it's technically attached to.

Think of it this way: when you first take out a mortgage on your home, that debt isn't deductible since it's tied to a personal expense. But if you start paying off that loan and then decide to redraw some of it to invest, then that portion now has an investment purpose. Suddenly, the debt is no longer purely for personal use. In the eyes of the ATO, that part of your debt is deductible because you’re using it to generate income.

With that same principle applied, the opposite can happen too. Just like you can have tax-deductible debt linked to your home, you can also end up with non-deductible debt on an investment property. You can’t claim tax deductions on an investment property loan that’s been used to pay off a personal home loan or buy a car.

In summary, as long as the borrowed money is working to produce income, you’re in safe waters for tax deductions. But if you’re in doubt, it’s worth getting a professional's help to make sure you’re staying within ATO rules.

How debt recycling can potentially increase your returns and help you pay off your mortgage faster

We mentioned this benefit briefly before. But it’s worth unpacking a bit more to understand exactly what's happening here and why it could be useful.

Let’s start with a basic hypothetical scenario. Imagine you have a $400,000 home loan sitting at a 6% interest rate, and we’ve also managed to save up $100,000. Now, let's say we take that $100,000 and invest it directly into shares. We might generate (as a hypothetical figure) around $4,000 in income from those shares over the year. However, once tax comes into play, assuming it's taxed 50%, we’d be left with only $2,000 of that income in our pockets.

That’s not too bad, but you’d probably be happier keeping more than that. That’s where debt recycling comes in. Instead of simply investing $100,000 from your savings, you can restructure your home loan into two parts. In a hypothetical scenario, let’s say you split the original $400,000 loan into a $300,000 portion and a $100,000 portion. You pay off that $100,000, which isn’t tax-deductible, and then redraw that money to invest in shares – just like before.

Here’s the key difference: while we still earn the same $4,000 in dividends from the shares, we can now also claim a $6,000 interest deduction on the $100,000 investment loan. For tax purposes, this creates a $2,000 “loss” on paper ($4,000 dividend income minus $6,000 interest expense). But assuming a tax rate of 50%, this paper loss translates to a tax refund of about $1,000.

At first glance, it might look like we’re in a worse position because there’s a paper loss here. But under certain conditions, you’re actually coming out ahead in this scenario. In both situations – whether we go with debt recycling or not – we still have the same $400,000 of debt and pay the same interest for the year.

We’ve also invested the same $100,000 in shares. But with debt recycling, we’re $3,000 better off because of how the tax outcomes play out. In our first what-if scenario, we paid tax on our dividends. In the second, we got a little refund instead. These savings will continue every year because the loan remains, and the purpose of that loan – investment – doesn’t change.

Of course, how much we benefit from debt recycling will depend on a few factors, like our specific tax rate and the interest rate on our loan. If we’re in a higher tax bracket or if interest rates are up, the potential savings may be more significant.

Conversely, with a lower tax rate or interest rate, the savings may be less pronounced. But even in a more modest scenario, the option to convert non-deductible debt into deductible debt can potentially improve your overall financial position.

Different ways to do debt recycling

Despite the previous examples, debt recycling isn’t just for folks with a massive lump sum in their offset account. That’s great if you’ve got it, but the reality is most of us don’t have $100,000 just lying around. So let’s talk about other ways to make it work that could be a better fit for your situation.

But before you go further: while we’ve laid out some hypothetical numbers up to this point, this is just the start of your research. Debt recycling can get quite technical, and the details can vary greatly depending on your situation. We've covered the basics, but consulting a professional will help you grasp the finer points and nuances any of us might miss on our own.

1) Multiple smaller splits

Here’s how it could work: Imagine you’ve got a $450,000 home loan and about $20,000 sitting in your offset account. Instead of waiting years to save up a big enough chunk to pay off a large portion of your loan, you could ask the bank to split your loan into smaller pieces. For instance, a $20,000 loan and a $430,000 loan.

This allows you to pay off that smaller $20,000 loan straight away. From there, you can start debt recycling with that portion, while still chipping away at the larger $430,000 loan. Over time, as you build up more savings, you can keep splitting off smaller chunks and recycling those.

But keep in mind, you probably can’t create endless loan splits. Banks might limit you to around ten splits. And each split might come with a small establishment fee, depending on your lender's rules. There are also minimum loan split amounts, usually around $20,000, but sometimes as low as $10,000.

In the end, it’s about finding a balance that works for you. On one hand, going too small might lead to too many fees or complexities. On the other, waiting for large sums can delay your investing. Hence, it’s worth chatting with your lender to see what’s appropriate for your situation.

2) Apply new loan to access home equity

If you’ve built up sizeable equity in your home, another approach is to apply for a new loan to access that equity. Now, despite how it sounds, you’re not necessarily adding more risk or increasing your overall debt level. Just like doing a lump sum or smaller splits, you’re still recycling your debt – turning it into an investment that’s more tax-efficient.

Here’s how it might work: you apply for a new, smaller loan against that equity and use it to create a fresh offset account. As you save money each month, you can pay down your main home loan as usual. Then, the trick is to take the extra amount you’ve paid off and draw that same amount from the new loan, which you then invest.

Important note: this strategy is more suited to folks who’ve held onto their property for a while and have seen its value increase. If you’ve recently bought your home, or if your loan-to-value ratio (LVR) is still quite high, this approach might not be right for you just yet. It’s more for those who have some equity built up but not a big pile of savings ready to go.

Debt recycling isn’t the same as leveraging debt, but there are perspectives to consider

A lot of the confusion often comes from thinking that debt recycling is like leveraging a debt – taking out a loan on a loan to invest. To be clear, they’re not one and the same.

In reality, with debt recycling, the amount of debt you have stays the same. You’re not going to the bank and saying: “Hey, I’ve already got a mortgage, so can I borrow more to invest in shares?”. You’re simply shifting how you use what you already owe. That way, you can potentially benefit from investing and tax deductions from its income, without taking on extra debt or risk.

Having said that, it’s worth noting that there are different ways to look at this. Some would suggest that debt recycling carries more risk than we might like to admit. After all, you’re choosing to invest rather than just focusing on paying down your debt. If your main focus is getting out of debt quickly while you can, then debt recycling may not be for you.

Even though you're not adding to your debt, some uncertainties are just part of anyone’s investing journey. Markets will go up and down – and, as we all recently learned, pandemics can happen too. These are things no-one can predict.

Understandably, you might feel a bit wary about how such circumstances could affect your finances. For instance, if you’re thinking about worst-case scenarios – say, interest rate hikes or losing a job – you might start to question whether those tax-saving benefits really hold up.

Ultimately, we're not here to push you in any direction. We're just laying out how debt recycling can work for you (or against you) in different situations. It’s not always easy to predict your reaction until you’re in the thick of it. But thinking it through now, ideally with professional guidance, can help you find a strategy that aligns with your risk tolerance and financial goals.

Final thoughts

Towards the end of this session, we’ve shared our own experiences with debt recycling – what we’ve done, what we’re planning to do, and how we see it moving forward. So, if you’re interested, we’ll leave those details for you to listen to yourself.

We know debt recycling raises a lot of questions – and you're not alone in that. That's why we recorded the next episode, where we tackle the most common questions and misconceptions people have about debt recycling. So, if there’s something we haven’t covered here, that episode is probably for you.

If you’ve got any specific questions in the meantime, feel free to reach out. You can find us on social media at Strong Money Australia and Pearler. Or, drop us a line at hello@aussiefirepod.com . We're always keen to hear your thoughts and help where we can.

Until next time, and happy investing!

Dave & Hayden