Debt Recycling Series Chapter 2: Why Debt Recycle and Is It Worth It?

Debt Recycling: A Smart Wealth-Building Strategy or a Risky Move?

Feb 11, 2025

Did you know your home loan could be the key to building wealth while tackling debt? Debt recycling is a strategy that many Australians use to pay off their mortgage faster and grow their investments at the same time by leveraging debt. While this approach has the potential to accelerate wealth-building, it also carries risks, such as market fluctuations and rising interest rates, making it important to assess whether it's the right fit for you. But is it the right choice for you? In this chapter, we’ll break down the benefits, risks, and essential features that make this strategy work.

Remember, it’s not for everyone, and seeking advice from a licensed financial expert is crucial to ensure this strategy aligns with your circumstances. Stick around for Chapter 3, where I share examples and tips to help you decide if debt recycling could fit into your financial journey.

⚠️ 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.

1. Why Consider Debt Recycling?

Debt recycling could help you use your home loan to get ahead financially. Here are three key reasons why people consider it:

a. Save on Tax When you borrow money to invest, the interest you pay on the loan is usually tax-deductible in Australia. By changing your home loan into an investment loan, you could reduce the amount of tax you pay.

b. Pay Off Your Mortgage Faster Money saved from tax deductions or earned from investments (like dividends or rental income) can be put straight back into your home loan. This helps you pay off your non-deductible debt faster, than just relying on your salary to pay down the debt. Increasing your cash flow is key!

c. Grow Your Wealth The goal is to use the money you borrow to invest in things like shares or property, where the returns are higher than the loan’s interest rate. Over time, this could help you build a solid financial future. For example, as of 2024, home loan interest rates are approximately 6% for many Australians, while the Australian share market has historically returned an average of around 9.8% annually over the long term (based ASX and RBA data). The difference between these figures represents the potential gain that could help build wealth. The difference is what you keep to build wealth.

2. Is Debt Recycling Right for You?

Debt recycling isn’t for everyone. Here’s how to figure out if it’s right for you:

a. Do You Have a Safety Net? It’s important to have a stable income and an emergency fund (enough for 6-9 months of living expenses), and manageable existing debts before starting. This would help reduce stress should an emergency happen and make sure you can still meet the repayments.

b. Are You Comfortable With Risk? Investing can be unpredictable. Shares and property values can go up and down, so this strategy is better for people who are okay with taking some financial risks and are ok with waiting for the market to recover should the market dips.

c. Are You In It for the Long Run? Debt recycling works best over many years. If you think your financial situation might change soon, it might not be the best time to start. This includes planning for a baby, house renovation, buying a car, etc. If you need the cash sooner, then you might be better off saving it in a high-yield savings account to avoid selling the investment at a loss when you need the money.

3. Financial Foundations to Have in Place

Before you dive into debt recycling, make sure you’ve got these basics covered:

a. Emergency Fund Keep at least 6-9 months’ worth of living expenses saved up. This is your safety net in case something unexpected happens.

b. Manageable Existing Debt Your current debts (like your home loan or credit cards) should be under control. Taking on extra debt without a plan can lead to stress.

c. Stable Income A reliable source of income is key to keeping up with repayments and handling market ups and downs.

d. Discipline Stick to your financial plan and don’t let emotions or impulsive decisions get in the way.

e. Professional Advice Talk to a licensed financial adviser or mortgage broker to make sure this strategy suits your situation.

f. Protect Your Income Consider income protection insurance to cover your expenses if you can’t work because of illness or injury for a longer time. Income Protection insurance typically has a waiting period (can be up to 90 days), so you may have to rely on your emergency fund until the waiting period is finished before the benefit kicks in.

Financial Foundations to Have in Place Before you dive into debt recycling, make sure you’ve got these basics covered: a. Emergency Fund Keep at least 6-9 months’ worth of living expenses saved up. This is your safety net in case something unexpected happens. b. Manageable Existing Debt Your current debts (like your home loan or credit cards) should be under control. Taking on extra debt without a plan can lead to stress. c. Stable Income A reliable source of income is key to keeping up with repayments and handling market ups and downs. d. Discipline Stick to your financial plan and don’t let emotions or impulsive decisions get in the way. e. Professional Advice Talk to a licensed financial adviser or mortgage broker to make sure this strategy suits your situation. f. Protect Your Income Consider income protection insurance to cover your expenses if you can’t work because of illness or injury for a longer time. Income Protection insurance typically has a waiting period (can be up to 90 days), so you may have to rely on your emergency fund until the waiting period is finished before the benefit kicks in.

4. How to Maximise the Benefits of Debt Recycling

There are two main approaches to making the most of debt recycling:

Option 1: Pay Off Debt Faster Use the extra money you make from investments and tax savings to pay down your home loan more quickly.

Pros:

You can become debt-free faster as you redirect extra income into paying down the principal.
It lowers your financial risk.
The focus stays on reducing debt.

Cons:

Your investments won’t grow as quickly as you're not topping up your investment and only relying on capital growth.
You might miss out on market opportunities.
The tax benefits might decrease as your debt gets smaller. As you keep paying down your investment debt, the interest charged on the debt gets smaller = less tax deductions.

Option 2: Focus on Growing Investments Reinvest the money you make from investments and tax savings to grow your portfolio over time.

Pros:

Your investments could grow faster as you redirect extra income to invest.
You might see bigger returns over the long term.
You take advantage of the Capital Gains. Capital Gains are not taxed like earned income. Capital gains are only taxed when you sell the asset, so you can accumulate growth until you retire when you have little to no income, lowering your tax. Furthermore any assets held more than 12 months benefit from 50% Capital Gains Discount.

Cons:

It’s riskier.
It could take longer to pay off your home loan.
You’ll need discipline to stick to this approach.

How to Maximise the Benefits of Debt Recycling There are two main approaches to making the most of debt recycling: Option 1: Pay Off Debt Faster Use the extra money you make from investments and tax savings to pay down your home loan more quickly. Pros: You can become debt-free faster as you redirect extra income into paying down the principal. It lowers your financial risk. The focus stays on reducing debt. Cons: Your investments won’t grow as quickly as you're not topping up your investment and only relying on capital growth. You might miss out on market opportunities. The tax benefits might decrease as your debt gets smaller. As you keep paying down your investment debt, the interest charged on the debt gets smaller = less tax deductions. Option 2: Focus on Growing Investments Reinvest the money you make from investments and tax savings to grow your portfolio over time. Pros: Your investments could grow faster as you redirect extra income to invest. You might see bigger returns over the long term. You take advantage of the Capital Gains. Capital Gains are not taxed like earned income. Capital gains are only taxed when you sell the asset, so you can accumulate growth until you retire when you have little to no income, lowering your tax. Furthermore any assets held more than 12 months benefit from 50% Capital Gains Discount. Cons: It’s riskier. It could take longer to pay off your home loan. You’ll need discipline to stick to this approach.

5. What Are the Risks?

Debt recycling can be a smart strategy, but it’s not without risks. Here are some things to keep in mind:

Market Volatility: The value of your investments could drop, especially in the short term. This could potentially leave you with a bigger debt than assets. If you needed to sell the asset quickly, the value of the asset wont fully clear your debt.
Rising Interest Rates: Rising interest rates could increase your monthly repayments, making it harder to manage. If you invested in assets that requires maintenance (such as investment property) the bigger mortgage repayment would further restricts your cashflow.
Borrowing Too Much: Taking on too much debt could cause financial stress if your investments don’t perform well.
Tax Compliance: If you mix personal and investment loans or don’t keep clear records, you might face issues with the ATO and can't claim tax deduction.

Key Points to Remember

Debt recycling can help pay off your home loan while building wealth, but it’s not for everyone.
Having strong financial foundations, including an emergency fund and stable income, is essential before starting.
The right loan features, such as split loans and offset accounts, can make the process smoother.
There are risks involved, including market volatility and rising interest rates, so careful planning is crucial.
Seeking advice from a licensed financial professional can help ensure this strategy aligns with your financial goals.

So, What’s Next?

In Chapter 3, we’ll explore practical examples and tips to help you decide if debt recycling is the right path for you. Stay tuned!

💬 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.