If you’ve got money left over after paying your bills each month, deciding where it should go isn’t always straightforward.
Should you make extra repayments on your mortgage? Put the money into an offset account? Invest in shares or ETFs? Boost your super? Or explore a strategy like debt recycling?
Most discussions stop at the first two choices: paying down your mortgage or investing. But that overlooks two strategies that can also play an important role in long-term wealth building: debt recycling and additional super contributions.
This guide explores two strategies that are often left out of the conversation – debt recycling and additional super contributions – how they work and when they may be worth considering.
Five places your spare cash can go
Discussions about paying off your mortgage often boil down to two choices: reduce your home loan or invest elsewhere. In reality, though, there are a few more options worth considering. Your surplus cash could go towards:
- Making extra repayments on your mortgage
- Keeping money in an offset account (we’ll dive into how this works further down)
- Investing outside super, such as in shares or ETFs
- Debt recycling
- Making additional super contributions
Extra mortgage repayments, offset accounts and investing outside super are all well-established strategies. Each has different advantages depending on your goals, appetite for risk and need for flexibility.
Rather than revisiting those in detail, this guide focuses on two strategies that are often left out of the conversation: debt recycling and additional super contributions.
What is debt recycling?
Debt recycling is a strategy that aims to make your home loan more tax-efficient while helping you build an investment portfolio over time.
Instead of investing your spare cash directly, you first use it to reduce your mortgage. You then borrow that amount back to invest in income-producing assets, such as shares or ETFs.
Why go through the extra step?
In Australia, the interest on an owner-occupier home loan generally isn’t tax deductible. However, interest on money borrowed to buy income-producing investments may be tax deductible, provided the relevant tax rules are met.
The important point is that it’s how the borrowed money is used that matters, not what asset secures the loan. For example, your home might still be the security for the loan. But if part of that loan is borrowed specifically to purchase income-producing investments, the interest on that portion may be deductible.
Debt recycling is simply a way of restructuring your borrowing over time so that some of your non-deductible home loan gradually becomes investment debt.
While the potential tax benefits attract plenty of attention, they’re only one part of the picture. Debt recycling also means borrowing to invest, so it’s generally better suited to people who already have a stable income, are comfortable with market ups and downs, and plan to invest for the long term.
You can learn more in this Aussie FIRE episode on debt recycling, and in Ana’s own story of employing debt recycling as a strategy.
How does debt recycling work?
At a high level, debt recycling follows the same basic process each time you have surplus cash available.
- Make extra repayments on your mortgage. This reduces the amount of non-deductible home loan debt you owe.
- Create a separate investment loan split. Rather than mixing investment borrowing with your everyday home loan, your lender creates a dedicated loan split for the amount you’re planning to invest.
- Borrow that amount to invest. The money from the investment split is then used to purchase income-producing investments, such as shares or ETFs.
- Keep clear records. Maintaining separate loan splits and good documentation makes it much easier to demonstrate how the borrowed funds have been used if needed.
Over time, you can repeat this process as you make additional repayments, gradually replacing some of your non-deductible mortgage debt with investment debt.
Why separate loan splits matter
One of the most important aspects of debt recycling is keeping your investment borrowing separate from your personal borrowing. If investment loans and personal spending are mixed together, it can become much harder to determine which interest may be tax deductible.
That’s why many accountants recommend setting up a dedicated investment loan split from the outset, rather than borrowing from an existing loan that has already been used for multiple purposes.
Offset account or redraw: why does it matter?
If you’re considering debt recycling, it’s important to understand the difference between an offset account and redraw. Although both can reduce the interest you pay on your mortgage, they work differently – and that distinction can matter for tax purposes.
- An offset account is a separate transaction account linked to your home loan. The money sitting in the account reduces the balance your lender charges interest on, but it doesn’t reduce the loan itself. Because you’re using your own savings, there are generally no tax implications.
- Redraw is different. It allows you to access extra repayments you’ve already made on your home loan. If you redraw money to renovate your kitchen or pay for a holiday, it’s generally considered personal borrowing. If you redraw money to purchase income-producing investments, the tax treatment may be different – but only if you can clearly demonstrate how those borrowed funds were used.
This is one reason many accountants recommend using a dedicated investment loan split for debt recycling. Keeping investment borrowing separate from personal borrowing can make record-keeping much simpler and help avoid complications later.
What are the risks of debt recycling?
Debt recycling can be an effective strategy in the right circumstances, but it’s not without risk. Because you’re borrowing to invest, your investment returns aren’t guaranteed, while your loan repayments still need to be made.
Some of the key risks include:
Markets can fall
Borrowing amplifies both gains and losses. If share markets fall shortly after you’ve invested, the value of your portfolio may drop while your investment loan remains the same.
Interest rates can rise
Higher interest rates increase the cost of servicing both your home loan and your investment loan. Before using debt recycling, it’s worth considering whether your budget could comfortably absorb higher repayments.
Tax benefits don’t guarantee better returns
A tax deduction reduces the after-tax cost of borrowing. It doesn’t make a poor investment a good one. Your investment still needs to perform well enough to justify the additional risk you’re taking.
Good record-keeping matters
Debt recycling relies on keeping investment borrowing separate from personal borrowing. If loan purposes become mixed, working out the tax treatment can become much more complicated.
Why super deserves a place in the conversation
When people compare paying off a mortgage with investing, there’s one option that often gets overlooked: making additional contributions to your super. Yet for many Australians, super is one of the most tax-effective places to invest for retirement.
If you’re eligible to make concessional (before-tax) contributions, you may reduce your taxable income while investing in an environment with concessional tax treatment. Non-concessional (after-tax) contributions don’t provide an upfront tax deduction, but earnings inside super may still benefit from favourable tax treatment compared with investing outside super.
Of course, there’s an important trade-off. Unlike money invested outside super (or cash sitting in an offset account), you generally can’t access your super until you’ve met a condition of release.
That’s why the question isn’t simply, “Should I invest or contribute to super?” It’s, “What is this money for?”
If you’re building flexibility or think you’ll need access before retirement, investing outside super or using an offset account may make more sense. If your goal is building wealth for retirement and you’re comfortable locking the money away, additional super contributions could be well worth considering.
Rather than treating super as an afterthought, it’s worth comparing it alongside your other options.
A simple framework for deciding
There’s rarely one perfect answer. Many Australians end up using several of these strategies at the same time, with the mix changing as their circumstances evolve.
A simple order to consider is:
1. Build an emergency fund
Having an emergency fund available for unexpected expenses can help you avoid taking on expensive debt or selling investments at the wrong time.
2. Pay off high-interest debt
Credit cards and personal loans usually carry much higher interest rates than mortgages, making them a sensible priority.
3. Decide how much flexibility you need
If you value easy access to your money, an offset account may suit you better than making extra mortgage repayments or contributing to super.
4. Invest regularly
If you’re investing for long-term wealth and can tolerate market ups and downs, building a diversified portfolio outside super may help you reach your goals.
5. Consider additional super contributions
If retirement is your priority and you won’t need the money for many years, super may offer valuable tax advantages.
6. Explore debt recycling if it suits your circumstances
Debt recycling is generally a more advanced strategy. It’s typically most appropriate for people who already invest regularly, have a stable income, understand the risks of borrowing to invest and have sought appropriate tax or financial advice.
There’s no need to rush to the final step. Many investors never use debt recycling, and that’s perfectly okay.
Ultimately, there’s no one-size-fits-all answer. Many Australians combine several of these strategies over time, like keeping an emergency fund in an offset account while investing regularly and making additional super contributions. As your income, mortgage and financial goals change, the right mix may change too.
