For many Australians, the mortgage is the largest financial commitment they’ll ever take on. It’s also one of the biggest obstacles standing between them and their long-term investing goals.

In this episode of Investing Compass we explore debt recycling - a strategy that aims to convert non-deductible home loan debt into tax-deductible investment debt over time. While the concept can sound complex, debt recycling is becoming increasingly popular among investors looking to build wealth more efficiently without waiting until their mortgage is fully repaid.

We unpack how debt recycling works, who it may be suitable for, and the risks investors need to understand before considering the strategy. We also discuss the behavioural challenges involved, the importance of maintaining financial flexibility, and why tax benefits should never be the sole reason for making an investment decision.

Whether you’re focused on paying down your mortgage, building an investment portfolio, or trying to balance both goals at once, this episode will help you understand the trade-offs involved and the key questions to ask before taking action.

You can find the full article here.

Below you can find more of our insights on mortgages and property:

Young & Invested: What happens if property prices go backwards?Could a generation of new buyers could be left trapped if the market turns?

Should retirees tap their home equity?Many retirees are cash poor and asset rich. There is a solution with reverse mortgages.

Future Focus: The decisions that make a difference to your mortgage The trade offs for key decisions with your mortgage.

Future Focus: The tax-free returns Aussies are taking advantage of There are smart ways to take advantage of your offset account, but balance is the key.

Is a mortgage actually ‘good’ debt? What does the explosion in mortgage debt mean for future property prices in Australia and highly geared homeowners.

Should you pay off your mortgage or invest? Our free tool can help investors decide if they should pay off their mortgage or invest.

You can find the transcript for the podcast below:

Mark LaMonica: Thanks to PocketSmith for sponsoring today’s episode. PocketSmith tracks your spending, income, and investments all in one place so you get a holistic view of your finances. PocketSmith has a special deal for Investing Compass listeners. Get 50% off on your first two months of the PocketSmith Foundation or Flourish plans. To get your deal, go to pocketsmith.com/investingcompass, or find the link in the podcast notes.

Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Shani Jayamanne: So today we’re going to speak about a strategy called debt recycling. And debt recycling is increasingly popular because there’s a cohort of Australian homeowners that are finding themselves in a similar situation. They have strong salaries that qualify them for a mortgage, but they’ve obviously got reduced cash flow because of the mortgage. And that strong salary has enabled them to purchase a home, but it comes with a higher marginal tax rate as well.

LaMonica: And debt recycling involves something that Australians love, and that’s gearing. So, it can either accelerate wealth creation. Gearing can either accelerate wealth creation if it works out well for you, or of course it can amplify your mistakes and really set you back.

Jayamanne: So typically, what we see is that the mortgage is the biggest liability on the household balance sheet. So, what debt recycling does is it restructures this debt, turning it into tax-deductible debt and increasing exposure to growth assets. And that is its definition in its simplest form.

LaMonica: So, this episode we’re going to run through – for anyone who is considering debt recycling, we are going to run through a definition, we’ll outline who it may suit, and we’ll talk about the potential opportunity costs. We’ll also run through an example of the difference it could make in your financial life.

Jayamanne: So, let’s start with what debt recycling actually is. So, at its core, debt recycling converts non-deductible debt into tax-deductible debt. So, to do this, there’s a few steps to go through. Start with 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.

LaMonica: And then you split the mortgage or you convert a portion of the mortgage into a redraw facility. You invest using borrowed money in return-producing assets, so a common one is investing in shares. Then you claim the interest on the deductible portion of the loan, which of course gives you tax savings, and then potentially you are generating income from these assets that you purchased that can then help you pay back the loan.

Jayamanne: So, this process is a way to diversify your assets, increase your tax efficiency, and reduce your mortgage. But you don’t get all this for free, you’re taking on 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.

LaMonica: And obviously that money that is sitting in your offset account is a tax-free return. So that’s the hurdle rate. It’s the set cost that needs to be exceeded for this to make financial sense for you. And that’s why people turn to equity investments. So, they’re a natural fit as you attempt to exceed that hurdle rate. But unlike your mortgage interest, there is no guarantee of capital growth or income from equity investments.

Jayamanne: You’ve also got to have an iron stomach for this because there is significant behavioral risk with debt recycling. If equity markets are volatile, you’ve got to be able to keep a long-term outlook and stay the course for this strategy to work in your favor.

LaMonica: That is what debt recycling is. Let’s talk about now who the strategy may suit. So, the first cohort is high income earners with stable employment.

Jayamanne: So not us.

LaMonica: No, no. It is increasingly unstable here. The higher your marginal tax rate, the larger the value of that tax deductible debt. And of course, stable employment is really important because you need to maintain cash flow and peace of mind so you can service that debt through any sort of market volatility that goes on.

Jayamanne: Then there’s investors with long time horizons. This strategy relies on compounding over time. The typical mortgage in Australia is 30 years. So, the earlier this strategy is used, the less risk. A short-time horizon increases risk.

LaMonica: And then lastly, investors that are comfortable with volatility. We talked about the behavioral risk associated with debt recycling, but you’ve got to be comfortable investing in volatile shares using debt.

So, self-awareness is really key here. You’ve got to focus on understanding yourself as an investor and whether this is something that’s actually going to work for you. There’s going to be market volatility and the leverage magnifies both the gains that you hopefully get and then of course the inevitable losses. So, you need patience to be successful. Understand whether you’re the type of person that can stick it out.

Jayamanne: So, let’s move on and let’s go through a quick example to run through the proof about why your marginal tax rate matters for this strategy. So, let’s take $1 million for a mortgage with a 6% interest rate. The recycle amount is $200,000 and we’ve got an investment return assumption of 7% per annum. The loan term remaining is 25 years and the annual interest on the recycle amount is $12,000 with total interest being $300,000.

LaMonica: For someone on a 47% marginal tax rate, including the Medicare levy, the effective interest rate becomes 3.18%. So that is total tax savings of $141,000. Then as an example, for somebody on a 30% marginal tax rate, it’s an effective interest rate of 4.2% and a $90,000 savings.

Jayamanne: And that’s a lot of numbers, but I’ve worked all this out and there’s a table that’s set out with some workings in my original article, which you can find in the episode notes. But the main purpose of debt recycling is to earn a higher return than you would with keeping the equity in your home. And key to this is your hurdle rate. And that refers to the return that you need to beat for an alternative investment to make sense.

LaMonica: So, in this case, using the example that we’re walking through, the hurdle rate is 6% because that is the mortgage interest rate. There’s no tax to be paid on this, as we mentioned, or any large transaction or administrative costs.

Jayamanne: Whatever you invest in has to beat that 6% hurdle rate over the long term. When it comes to debt recycling, because your debt becomes deductible, it cancels out that tax that you might have paid on potential investment income. But just achieving over a 6% return doesn’t make the strategy worthwhile. It is a compounding of the funds over a long time horizon that makes that real difference to total outcomes.

LaMonica: And of course, your whole return is likely not investment income. So, you’re also delaying paying tax until you sell out of those assets.

Jayamanne: 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 and equity returns is the engine that drives this strategy.

But just keep in mind that this spread is not guaranteed, especially each year, and this is a risk that’s earned by investing in equity markets.

[Advertisement: PocketSmith directly connects to your accounts. So, there’s no manual tracking. It offers cash flow forecasts so you can properly plan and transparent for you to make better decisions.

We’ve been using it ourselves. And what stands out is how it brings everything together in one place. You can see your spending, your income, your investments, and it gives you a proper view of your net worth. If you’re trying to get a clear picture of your finances alongside your investing, PocketSmith has a special deal for Investing Compass listeners. Get 50% off on your first two months of PocketSmith’s Foundation or Flourish plans. To get your deal, go to pocketsmith.com/investingcompass or find the link in the podcast notes.]

LaMonica: And one of the really common questions that we get when we’re out there talking to investors is whether they should focus on their mortgage first or invest concurrently as they’re paying off their mortgage.

And of course, your hurdle rate really does matter for this. We went through that example showing that investing for 25 years for someone in the highest marginal tax rate leads to $1 million. The alternative is that that person chooses to aggressively pay down $200,000 over 10 years and then begins investing. 15 years, if you start investing then 10 years in the future, after 15 years with the same return, you’ll get $551,000.

Jayamanne: And time in the market really does matter for your outcomes here. But all of these numbers are in theory. Nothing is guaranteed. Even in that example, the end outcome assumes you get even returns every year. The sequence that you get those returns will alter your outcomes as well.

LaMonica: So really what we’re trying to build the case for is that, yes, debt recycling can technically work out for you, but you need a long time horizon for all these variables to decrease the risk that you end up with a subpar outcome because of volatility.

Jayamanne: So, let’s talk about the risks while we’re at it and let’s start with volatility. Anytime you invest using borrowed funds, the risk is higher. If you invest in the equity market and experience a market drop or a long downturn, the borrowed amount doesn’t change. So, 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 your mortgage.

LaMonica: And you can manage this if equity markets recover over the long term. But this can be an issue if you panic sell, the recycled amount is too large or your income becomes unstable.

Jayamanne: The next risk is cash flow management. You’re increasing your loan amount by drawing down on funds. And this means that your interest expenses will increase in the short term until you receive your tax refund. This cash flow will need to be managed.

LaMonica: And then of course, there are interest rates. As we’ve seen this year, if you’re on a variable loan, interest rates aren’t 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 this is just a temporary increase. And this could also mean that there is a shortfall between the tax saved and the difference in the mortgage payments.

Jayamanne: All right. So that is one-on-one on debt recycling, the opportunities and the risks. If you’re in a higher marginal tax rate, the lifetime savings can be substantial, especially when you take a step back and combine that with the increased market exposure that compounds over the long term.

LaMonica: But remember, a positive outcome isn’t guaranteed. The return that you get from funds, additional funds in your mortgage is a guaranteed return. So, there are risks involved if any of those other variables change – your salary, your marginal tax rate, the interest rate on your mortgage or market returns. So, you’ve got to be actively monitoring the situation to manage your cash flows.

Jayamanne: And if you choose to deploy this strategy, ensure you have a cash flow 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 behavior during times of volatility.

LaMonica: Great. Well, thank you very much for joining our episode on debt recycling. As Shani mentioned, there’s a link to her article with all of those tables in the show notes.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

Invest Your Way

A message from Mark and Shani

For the past five years, we’ve released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.

We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.

If anyone would like to support this project you can buy the book now. Thanks in advance!

Purchase from Amazon

Purchase from Booktopia