Future Focus: Make your mortgage tax deductible
Debt recycling can be an attractive strategy for those on higher marginal tax rates. I run through how to know whether it is right for you.
Many Australian homeowners find themselves in a similar situation. They have a strong salary that has qualified them for a mortgage, but reduced cashflow – because of the mortgage. That strong salary enabling the purchase of a home comes with higher marginal tax rates.
One option that is increasingly popular with this cohort is debt recycling. However, like most financial strategies involving gearing, it can either accelerate wealth creation or amplify mistakes.
Typically, the mortgage is the biggest liability on the household ‘balance sheet’. Debt recycling ‘restructures’ this debt, turning it into tax deductible debt and in parallel, increasing exposure to growth assets.
For anyone considering debt recycling I’ve provided a definition, outlined who it may suit and the shared my thoughts on potential opportunity costs. I’ve also mapped out an example of the difference it can make.
What is debt recycling?
At its core, debt recycling is converting non-deductible debt into tax deductible debt. To do this involves:
- Paying off part of the mortgage to increase the equity in your home. A portion of this equity is what can potentially be unlocked for debt recycling.
- Splitting the mortgage or converting a portion of the mortgage into a redraw facility.
- Investing using borrowed money in return producing assets, such as shares.
- Claiming the interest on the deductible portion of the loan for tax savings.
- Potentially generating income from assts that can help pay off the loan.
Debt recycling is a way to diversify your assets, increase tax efficiency and reduce your mortgage quicker. However, this is not without risk. Debt recycling involves taking a bet that the net return from the market and tax savings will beat the interest rate that you are paying on your mortgage, on which you pay no tax.
This is your hurdle rate - it is a set cost that must be exceeded. Equity investments are the natural fit for attempting to exceed the hurdle rate. However, unlike your mortgage interest, there is no guarantee for capital growth or income from equity investments.
Debt recycling also has significant behavioural risk. If equity markets are volatile, you must be able to keep a long-term outlook and stay the course for this strategy to be beneficial.
Who debt recycling may suit
High income earners in stable employment
The higher your marginal tax rate, the larger the value of the tax-deductible debt. Stable employment is required to maintain cashflow and peace of mind servicing investment debt through volatility.
Investors with long time horizons
This strategy relies on compounding over time. The typical mortgage in Australia is 30 years. The earlier this strategy is utilised, the less risk. A short horizon increases the risk.
Investors comfortable with volatility
You must be comfortable investing in volatile shares using debt. Self-awareness matters so focus on understanding yourself as an investor and what you are trying to achieve – there will be market volatility, and leverage magnifies both gains and losses. Patience is needed for the strategy to be successful.
Why your marginal tax rates matter
It’s worth understanding why your marginal tax rate matters, and why a higher marginal tax rate is more attractive for this strategy.
Scenario
Tax bracket differences
Assuming no change in interest cost on the recycled portion for simplicity
When invested
The main purpose of debt recycling is to earn a higher return than you would with keeping the equity in your home. My colleague Mark has written about hurdle rates before. Hurdle rate refers to the return you must beat for an alternative investment to make sense. The hurdle rate in this case is 6%, which is our mortgage interest rate. There’s no tax to be paid on this, or any large transaction or administrative costs. The hurdle rate is unaffected.
Whatever you invest in must beat the 6% hurdle rate. When it comes to debt recycling, your debt becomes deductible. This ‘cancels out’ the tax that you may pay on potential investment income. However, it isn’t just achieving over a 6% p.a. return that makes this strategy worthwhile. It is the compounding of the funds over a long time horizon that makes a real difference to total outcomes.
If $200,000 is invested for 25 years, the result is over $1 million at a 7% return. It is $858,000 at a 6% return.
The difference between the after-tax borrowing cost (3.18% - 4.2%) and equity returns (6-7% used in this example) is the engine driving this strategy. It is important for investors to keep front of mind that this spread is not guaranteed, especially each year. It is earned by the risk that you take on in equity markets.
Opportunity cost: sequential vs concurrent capital allocation
I’m often asked whether investors should focus on the mortgage first, or to invest concurrent to their mortgage. The hurdle rate is a key figure in determining the right direction. The example showed that investing for 25 years for someone in the highest marginal tax rate leads to over $1 million. The alternative could be that an individual chooses to aggressively pay down $200,000 in 10 years and then begins investing. 15 years with the same return would result in $551,000.
Time in the market compounds to result in a significant difference of outcomes. The reality, however, is that this figure would be heavily impacted by the sequence of returns. Early negative returns can alter outcomes materially.
The other opportunity cost is understanding whether the funds are better invested in superannuation, towards retirement. The lower tax rate in superannuation means that investments in super are attractive for those on a higher marginal tax rate as well. Mark has also written about this here. It may be worth considering if there are any remaining amounts left in concessional caps for the household. If these are fully utilised, debt recycling may be an alternative option.
The risks
Volatility
Any time you invest using borrowed funds the risk is higher. If you invest in the equity market and experience a market drop or prolonged downturn, the borrowed amount does not change. For example, if you recycle $200,000 and the market drops 30%. Your portfolio is now $140,000, but you still owe $200,000 on the mortgage.
This can be managed if equity markets recover over the long term, but can be an issue if investors panic sell, the recycled amount is too large, or income becomes unstable.
Cashflow
The other risk is cashflow management. You are increasing your loan amount by drawing down on funds. This means that your interest expenses will increase in the short term, until you receive your tax refund. This cashflow will need to be managed.
Interest rates
For those on variable loans, interest rates are not stagnant. There is a chance that while the funds are invested in equity markets, the rate on your loan rises. This increases the hurdle rate, even if just temporarily. This may mean that there is a shortfall between the tax saved and the difference in mortgage payments. Cashflow is a key consideration.
Final thoughts
Debt recycling increases both risk and potential reward. For those in higher marginal tax rates, the lifetime savings can be substantial. Combined with increased market exposure that compounds, the difference over 15-20 years can be meaningful.
A positive outcome is not guaranteed. The ‘return’ that you get from your funds in your mortgage is. There are risks involved if any other variable changes – your salary, your marginal tax rate, the interest rate on your mortgage, or market returns.
If you choose to deploy this strategy, ensure you have a cashflow buffer and you understand how this fits into your broader long-term investment strategy. This will reduce the likelihood that you sabotage yourself with poor behaviour during times of volatility.
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