Is debt recycling a good strategy?

Two good friends of mine are halfway through a rebuild of their home. They knocked their house down, moved into a rental unit and are awaiting the completion of their new home. They have talked about this project for years and it has taken a lot of time and effort to get to this stage.

We had an interesting conversation last time I caught up with them. It seems that they are seriously considering selling the house, paying off their mortgage and trying to find another place to buy that requires less debt. The fact that debt is involved in this project should not come as a surprise. Just buying a house in Sydney is expensive. Knocking that house down and rebuilding another one adds to the debt burden.

This whole conversation caused me to think about debt and a question I have received numerous times following a series I wrote on housing last year. New homebuyers find themselves forced to take on ever increasingly levels of debt to afford a home. This is of course a voluntary decision. You don’t have to buy a house and I have chosen to rent. However, many people don’t believe it is a choice given societal expectations and the desire to have a stable place to raise a family.

What is unequivocally a voluntary decision is to take on additional debt to pursue a strategy to improve your financial situation. And that is the question I keep receiving. Is there merit in debt recycling?

There are four considerations for someone considering a debt recycling strategey:

1. What is debt? Can it ever be good?
2. Should you care about your net worth?
3. What return makes debt recycling worthwhile?
4. Are you giving up the main advantage of your primary residence?

I will share my personal views on each of these considerations but first a definition of debt recycling is in order.

What is debt recycling?

Debt recycling is taking equity in your home and borrowing against it to invest in other assets. Examples of other assets include shares or an investment property.

The prerequisite to debt recycling is having equity built up in a primary residence. This can occur after a mortgage has been partially repaid or if a property has appreciated in value. The idea is to tap that equity by taking out an investment loan. The proceeds from that loan can be invested in an investment property or in another type of investment.

How are loan proceeds invested?

For an investment property the loan would be used as a down payment and a mortgage on the new property would pay for the rest. That property would generate income that would at least partially cover the mortgage payments and maintenance. The interest on the investment property, any expenses incurred, and depreciation would be tax deductible.

Any cashflow shortfall could be deducted against other sources of income such as wages. The future goal is for the property to become positively geared or appreciate in value enough to cover the cost of the loans.

The proceeds of the loan could also be invested in the share market although this is a less popular and more risky approach because there are no tax deductions. In this case another loan would not be needed to invest although some investors choose to go down this path. The goal is for the returns earned in the share market – after transaction costs, fees and taxes – to exceed the interest on the loan.

Share market investments do earn income in the form of dividends and distributions. Depending upon prevailing interest rates it is possible that the investment income could cover the cost of the loan. Chances are it won’t. In that case capital appreciation is needed. The share market is notoriously volatile and long holding periods are important to overcome short-term volatility.

Given that the income earned from the share market investment will likely not exceed the cost of the loan it is important to have a source of cashflow that can cover the difference. Remember that the share market returns we often hear are index returns. That is not the return that an investor will receive.

Even if you buy and hold an index fund your return will be less than the index. The index fund will have fees. There will likely be transaction fees when the index fund is purchased and sold. Capital gains will be passed along as part of the distributions and when the investment is sold.

Many investors also underperform because of poor behaviour. Buying and selling at the wrong time take a toll on returns. Assume you will make some poor investment decisions because even the best investors make mistakes.

What is debt? Can it ever be good?

Central to the sales pitch for debt recycling is the concept that there is good debt and bad debt.

There are varying definitions of good debt and bad debt. One definition is that good debt is taking out a loan to purchase an asset that will help to build your long-term wealth while bad debt is taking out a loan to fuel consumption. Another definition is that good debt is tax deductable and bad debt is not tax deductible. To meet that threshold of tax deductibility the debt from your primary residence would have to be used to purchase an investment property.

There is a bit to unpack here. All debt is limiter of future options and a drain on future cash flows. It is an obligation that must be paid back. Tax deductibility may reduce the drain on future cash flows but it is not eliminated. The deduction is only applicable to the interest portion of the loan and not the principal. However, other deductions are available as previously mentioned. A mortgage is an amortising loan which means over time the portion of a mortgage payment going to principal will increase which reduces the amount of interest that is tax deductible.

The fact that debt limits future options and reduces future cash flows simply means careful consideration needs to be paid to the growth potential of the asset purchased and the amount of income generated going forward. This must be weighed against the cost of the debt or interest rate. Given the variable nature of interest rates and the unknown future returns of any asset several scenarios should be considered.

Taking out additional debt increases the risk to your finances. Proponents of debt recycling always focus on the positives. That equity in your primary residence is just sitting there and should be put to use. Fair enough. Just remember that debt may amplify your returns but it also amplifies your risk.

What return makes debt recycling worthwhile?

This seems like an obvious step. Yet I’m willing to bet a fair amount of people who pursue this strategy don’t bother to run the numbers. I constantly hear that the return earned on an investment purchased with debt recycling needs to simply exceed the interest rate paid on the loan. This isn’t even close to accurate.

In a theoretical world it is true that borrowing money at 5% and investing it at 8% is a profitable endeavour. Yet in the real world we have to worry about taxes and transaction costs. We also have to account for deductions received and the tax minimisation effect of any deductions. What matters in all investing is the return that accrues to the investor.

Transaction costs are an obvious component that reduce your returns. Just remember that if debt recycling is being used to purchase real estate the transaction and maintenance costs can be very high. People tend to focus on the purchase and sale price of property but fail to account for interest expenses and constant maintenance and upkeep costs. Not to mention high transaction costs when you buy or sell a property.

One of the biggest considerations for debt recycling is tax. This can be quite complicated and is influenced by marginal tax rates, where assets are held (in super or outside of super) and the deductibility of interest and expenses. In both taxes owed and the value of deductions the marginal tax rate matters.

If this is a strategy that you wish pursue it is critical to know exactly what return is needed to make it worthwhile financially given your personal circumstances. Model out different scenarios where interest rates and your marginal tax rate change. Build in a buffer.

If you are pursuing this strategy based on professional advice have the advice provider give you the exact returns needed under different scenarios. Take the time to understand how they have calculated the return. And don’t think that just because a lender is willing to give you money it is a good idea. Lenders only worry about your ability to pay back the loan. They don’t care if repaying the loan cripples your finances.

Should you care about your net worth?

As a society we are obsessed with net worth. That is why we measure financial milestones the way we do. We describe successful people based on the rung of the net worth ladder they reach. Millionaires, multi-millionaires, and a select few billionaires are the labels we associate with financial success.

Yet most of us live our lives in very different ways. What governs our day-to-day spending and less frequent splurges like trips is our cash flow. How much money is coming into our bank accounts and how much is going out.

The wealth effect is illusionary. We may feel more comfortable spending more if the long-term assets we hold increase in value, but should we? I’ve never spent much time worrying about my net worth. My focus has always been on cash flow and trying to keep my fixed obligations like housing low in comparison to my discretionary spending. This provides me with more safety as I can scale down discretionary spending when faced with the inevitable financial challenges life throws at everyone.

Debt repayments are a fixed obligation. Increasing fixed obligations through debt recycling to buy assets may be a good strategy to increase net worth. But does it increase financial security? Does it increase life satisfaction?

I have some qualms with some of the messaging in Bill Perkin’s book Die with Zero but I do agree with the central point. The measure of a life is our accumulated experiences. And while some experiences are free, most cost money. And those experiences come from the cash flow that supports discretionary spending. Increase the portion of your cash flow that is discretionary and you increase choice. Should I spend my discretionary cash flow on a weekend away? A nice dinner? A charitable donation? That is freedom.

This may seem like a fuzzy argument against debt recycling, but the philosophical underpinning of any financial strategy matters. If you are more focused on building your net worth, consider how and when those assets will be converted to cash that can be spent. And be realistic about the cash that is coming your way when you sell those assets. Transaction costs and taxes can take a large chunk out of your net worth on paper.

Are you giving up the main advantage of your primary residence?

It is probably obvious that I am not a fan of debt in any form. My goal is financial independence. Owing a pile of money to a bank is not independence regardless of the value of the assets you partially own by taking on that debt.

Owning a home does provide financial benefits. The first is forced savings. I don’t agree that renting is ‘throwing money away’. It is simply paying for an essential service. Something that all of us do every day. However, a portion of a mortgage payment goes to paying back principal which increases the equity in your home.

As previously mentioned, a mortgage is an amortising loan. The forced saving component of a mortgage increases over the years. Below is an example of an amortisation schedule for a 30-year loan for $500,000 at a 5% interest rate.

In the first year of the loan interest makes up approximately 77% of the total payments. It is not until the 17th year for half of a mortgage payment to be ‘forced savings’. This is just part and parcel of taking out a mortgage. The beauty of making additional payments on your mortgage is that you jump ahead on the amortisation schedule. More of your future payments will go towards principal and you will build equity in your home faster.

The problem with a debt recycling plan is that you are taking equity out of your home. In this case you are jumping backwards in your amortisation schedule on an aggregate basis. A higher component of the combined future payments to your original mortgage and the investment loan will go to interest than if the extra loan wasn’t taken out.

There are other consequences to this decision. In the 1950s and 1960s people threw parties to celebrate paying off their mortgage. Many people may scoff at that concept and consider it quaint. We like to think of ourselves as more financially sophisticated than our forbearers.

Yet families throwing mortgage parties knew something that too many people choose to ignore today. They knew the best part of homeownership from a financial standpoint is when a mortgage is paid off. They understood the benefit of staying in a single home for life and working their way down an amortisation schedule while avoiding the excessive transaction costs of climbing the rungs of the property ladder from starter to forever home.

Were our forebearers more financially enlightened? Of course not. They borrowed less because regulations prevented taking loans of the size that are routinely handed out today. They didn’t need to climb the property ladder because they could afford a ‘forever’ home early in their working lives. Our greater access to credit today doesn’t change the fact that paying off a mortgage is a huge benefit to household finances.

If paying off a mortgage is so beneficial than why make it harder by taking equity out of a home? It is certainly something to consider.

My thoughts

I cannot think of any scenario where I would ever use debt recycling. That is just me. It doesn’t mean anyone should follow this approach. I have a natural aversion to debt. I see it as a limiter of flexibility given the extra obligation against my future earnings.

As a society we have gotten far too comfortable with levels of debt that earlier generations would see as wildly excessive. Higher personal debt levels do stem from higher house prices. I sympathise with people forced to take on too much debt to afford a home. I think we would be better off as a society if housing prices went down. But this article is not about buying a home. It is about voluntarily taking on more debt to grow personal wealth.

The two friends I mentioned at the beginning of the article are reassessing their own debt levels and what brings them happiness. I don’t know what decision they will ultimately make. What I do know is that they are dreamers and want so many things from life. It is inspiring to listen to their visions for the future. It is that context we need to bring to our financial decisions. They should be based on what brings us joy and fulfilment in life.

I will admit that my aversion to debt borders on irrational. Yet it is consistent with my underlying financial philosophy. My view of financial success is to maximise my discretionary spending. That involves increasing the cash flow from my salary and investment income. It also involves keeping my spending on ‘needs’ as low as possible to provide more money for the things I enjoy. That is how I maximise the enjoyment in life.