Debt Recycling Series Chapter 1 : What is Debt Recycling & How Does It Work?
How I Used My Mortgage to Build Wealth and Unlock Tax Benefits
Debt recycling is a strategy that transformed my finances—it helped me grow my net worth by $450K in just 1.5 years. In this chapter, I’ll take you through what debt recycling is, how it works, and why I don’t pay off my mortgage or use an offset account against my home loan.
⚠️ Disclaimer ⚠️
This content is for educational purposes only and does not constitute financial advice. The examples provided are hypothetical and based on assumptions. Your financial situation and results may differ. Debt recycling involves risks, including market volatility and changes in interest rates. This content does not recommend or promote any specific financial product or service. Always consult with a licensed financial advisor, tax professional, or mortgage broker to ensure this strategy aligns with your personal circumstances.
What is Debt Recycling?
Debt recycling is a strategy that allows you to turn part of your home loan into an investment loan. It works by changing the purpose of a portion of your home loan—from personal use (e.g., buying your home) to investment use (e.g., purchasing shares, ETFs, or other income-generating assets).
In simple terms, it converts “bad” debt into “good” debt. Here’s why:
Home Loan (“Bad” Debt): This is debt used to purchase a personal-use asset, like your home. It doesn’t generate taxable income, nor does it provide tax benefits.
Investment Loan (“Good” Debt): This is debt used to purchase income-generating assets like shares or property. The interest on this type of loan may be tax-deductible because the investment generates taxable income.
How Does Debt Recycling Work?
Debt recycling usually follows these steps:
1️⃣ Using Your Equity: You pay down your home loan and borrow or redraw the same amount.
2️⃣ Investing: The borrowed funds are used to purchase income-producing assets, such as shares or ETFs.
3️⃣ Claiming Tax Benefits: Since the portion of the loan is used for investing, that portion’s interest may be tax-deductible (provided you meet the Australian Tax Office (ATO) rules).
The Debt Recycling Process
Here’s how it works in four simple steps:
Make extra repayments on your home loan to reduce the balance.
Redraw or split the loan into a separate investment loan.
Invest the borrowed funds in income-generating assets like shares, ETFs, or managed funds.
Claim a tax deduction on the interest for the investment loan.
Why Not Open a Separate Investment Loan?
If this sounds complex to you, you might wonder: “Why not just open a new loan for investment?”. Here’s the key advantage: Debt recycling doesn’t require you to open a separate investment loan, which often comes with higher interest rates.
Debt-Recycled Portion of a Home Loan:
Instead of opening a whole new loan, debt recycling reuses part of your home loan for investing.
The key is keeping it separate by creating a loan split.
This makes it clear which part of your loan is for personal use (non-tax-deductible) and which part is for investments (tax-deductible).
Investment Loan for Investment Property has higher rates:
If you wanted to invest in property, the loans for investment property typically has interest rates 0.3% to 1% higher than a home loan.
Investment Loans for Stocks (Margin Loans) Are Expensive:
If you wanted to invest in shares or ETFs and take out a margin loan, these loans typically have very high interest rates (8-12%) and come with more risk (e.g., margin calls if the market drops).
By splitting and redrawing your home loan to invest, you avoid these higher costs while still enjoying the tax benefits of investment debt.
Why People Debt Recycle?
In Australia, interest on loans used for income-generating investments can be tax-deductible (if you follow ATO guidelines). This approach allows you to reduce taxes while potentially growing wealth over time. However, it’s important to understand that debt recycling involves risks, such as market downturns or rising interest rates, and requires careful planning and detailed record-keeping. Always check if this suits your financial situation by speaking with a licensed financial advisor or tax expert.
How Tax Works When Borrowing to Invest
While many people considers their home as an “asset”, it is not an income-producing asset. The tax system rewards certain investments that generate income and the Australian Taxation Office (ATO) allows you to claim a deduction on the interest of a loan used for investment purposes. This is why investment loans are tax-deductible, while typical home loans are not.
For interest to be deductible:
Tax deductions depend on how the loan is used, meaning the loan must be used to purchase income-generating assets.
The investment must generate an income. The income generated by these assets (e.g., dividends or rent) must be assessable and taxable in Australia.
You need to follow ATO rules to claim deductions.
There is a strict criteria for what would be considered an ‘income-producing assets’. For example, it cannot be a personal collectibles as expensive artwork, watches or fancy cars because it doesn’t generate an assessable income. Speak to a tax professional to ensure the asset is eligible and to avoid costly mistakes.
Examples (Hypothetical Only)
Let’s walk through the three common scenarios to help you understand why debt recycling could be a smarter strategy for wealth building compared to traditional approaches. In these examples, we will ignore capital growth of the house (as they would be the same across all 3 examples and we’re only focusing on the variables).
Disclaimer: The examples below are based on hypothetical scenarios and assumptions and should not be considered a financial advice or recommendation. Your financial situation and results may differ. While it may be a better outcome mathematically personal finance is not just about numbers. Everyone’s situation, emotions and risk appetite are different. Just because the number looks better, doesn’t mean it is the best option for you. Always consult with a licensed financial advisors and tax experts before implementing this strategy.
Scenario 1: Offset Account (no Debt Recycling)
The Setup
Home Loan: $500K at 6% interest.
Offset Account: $100K.
What Happens
The $100K in the offset account reduces the loan balance to $400K, reducing interest paid to the bank.
Annual interest saved $6,000.
The Result
While offsetting a home loan reduces the total interest paid, it does not actively grow wealth. The interest saved is not additional cash flow, as loan repayments remain the same. Instead, a greater portion of each repayment is directed toward paying down the principal, which reduces the loan term but does not generate investment returns.
The $100K in the offset account do not generate income or compounding returns, unlike invested capital. While offsetting improves loan efficiency, it does not provide the potential for capital growth, dividend income, or other forms of investment returns that can contribute to long-term wealth accumulation. Additionally, as offset accounts do not generate passive income, they do not improve cash flow.
Scenario 2: Investment Directly (No Debt Recycling)
The Setup
Home Loan: $500K at 6% interest.
$100K used to purchase shares outright, leaving the $500K home loan unchanged.
What Happens
Annual loan interest paid = $30,000 ($500K × 6%)
The $100K investment generates:
3% dividends = $3,000/year.
6% capital growth = $6,000/year.
Dividends are taxable at a marginal tax rate (let’s say 37%), so you pay $1,110 in taxes on the $3,000 dividends.
The Result
Net dividend income after tax: $1,890.
Capital growth: $6,000 (unrealised until the shares is sold, so this gain is not taxed yet).
You’re ahead by $7,890 in Year 1, but you pay higher taxes because there’s no loan interest to deduct.
Scenario 3: Debt Recycling
The Setup
Home Loan: $500K at 6% interest.
Pay $100K off the home loan, then borrow back/redraw it as an investment loan to purchase shares.
What Happens
Split the home loan into:
$400K home loan (non-deductible).
$100K loan that will be fully paid off with the $100K cash and redrawn to buy investments. This step changes the purpose of the loan into investment loan (tax-deductible).
Annual loan interest:
$400K home loan = $24,000.
$100K investment loan = $6,000 (tax-deductible).
The $100K investment generates:
3% dividends = $3,000/year.
6% capital growth = $6,000/year.
You claim a tax deduction on the $6,000 interest on the investment loan, saving $2,220 (37% marginal tax rate).
Dividends are taxable at 37%, so you pay $1,110 in taxes on $3,000 dividends.
The Result
Net dividend income after tax: $1,890.
Tax savings: $2,220.
Capital growth: $6,000 (unrealised until the shares is sold, so this gain is not taxed yet).
Net outcome: $10,110 in Year 1.
Comparison of Results
Key Takeaways from the Scenarios
Offset Accounts Are Limited
While an offset account reduces the interest payments, it doesn’t actively grow your wealth or unlock tax benefits.Investing Outright Increases Taxable Income
Buying investments outright helps you grow wealth, but you pay more tax because there are no deductions to offset your gains.Debt Recycling Offers the Best of Both Worlds but it is Higher Risk than The Other Two Scenarios
Reduce non-deductible debt.
Unlock tax deductions on investment loan interest.
Grow investments through income and compounding returns.
However, the following risks are to be considered:
Market Downturns: if the market crashed, the investments can lose value. You might end up with a loan amount that is bigger than the asset value, meaning selling the asset during downturns may not fully cover the debt and the debt still have to fully repaid.
Rising Interest Rates: Higher loan repayments could reduce your returns.
Complexity: Detailed record-keeping is essential to ensure tax compliance.
Key Points to Remember
Income Matters
The investments must generate assessable income (e.g., dividends or rent) for the interest on the loan to be tax-deductible.
It’s Not Risk-Free
Tax deductions reduce costs but don’t eliminate risks like market downturns or rising interest rates.
Track Expenses Carefully
Keep detailed records of loan repayments, redraws, and investment transactions to ensure you claim the correct deductions.
Plan Ahead for Tax Timing
If you sell investments for a profit, you might need to pay Capital Gains Tax (CGT). But the tax-deductible interest can offset these gains to reduce tax burden.
So, What’s Next?
In the next couple of chapters, we’ll dive deeper into the pros and cons of debt recycling, so you can assess whether it’s the right fit for your financial goals, and discuss how to mitigate risks effectively with a licensed financial advisor.
💬 Got a question about debt recycling? Drop it in the comments—I might include it in the FAQ chapter at the end of this series.
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⚠️ Disclaimer ⚠️
This content is for educational purposes only and does not constitute financial advice. The examples provided are hypothetical and based on assumptions. Your financial situation and results may differ. Debt recycling involves risks, including market volatility and changes in interest rates. This content does not recommend or promote any specific financial product or service. Always consult with a licensed financial advisor, tax professional, or mortgage broker to ensure this strategy aligns with your personal circumstances.
Definitions and Terms for Beginners
Good Debt: Debt used to acquire assets that grow in value or generate income, like a mortgage, student loan, or investment loan.
Bad Debt: Debt used for things that lose value or don’t generate income, like credit card debt, payday loans, or car loans for luxury vehicles.
Assessable Income: Income that is subject to tax, such as wages, dividends, or rental income.
Tax-Deductible: An expense that reduces your taxable income, which can lower the amount of tax you owe.
Equity: The difference between your property’s market value and the amount you owe on your mortgage. For example, if your home is worth $600,000 and you owe $400,000, your equity is $200,000.
Offset Account: A bank account linked to your home loan. The balance in this account reduces the amount of your loan on which interest is calculated, saving you money on interest payments.
Capital Growth: The increase in the value of an investment over time. For example, if you buy shares for $100 and they increase in value to $120, the capital growth is $20.
Dividends: Payments made by a company to its shareholders, usually from profits.
Investment Loan: A loan specifically used to purchase income-producing assets, such as shares or property.
Redraw Facility: A feature that allows you to access extra repayments you’ve made on your loan.
ATO (Australian Taxation Office): The government body responsible for managing Australia’s tax system.
Capital Gains Tax (CGT): A tax on the profit made from selling an asset, such as shares or property, for more than you paid for it.
Income-Producing Asset: An asset that generates income, such as rent from a property or dividends from shares.