There’s a common misconception about debt recycling that’s often passed around by bloggers and others online and this misinformation can cause you to actually increase the amount of debt you’re taking on. It’s time to clear that up.
What is debt recycling and what is it not?
People often think that debt recycling is using the equity in your home to invest. For example, let’s say that you have a $400,000 mortgage, and your home goes up in value. The incorrect information on the internet says that refinancing and borrowing an extra $50,000 to invest is debt recycling, when in fact, that’s not the case.
Debt recycling is investing in a tax-effective way. To use the same example, let’s keep your $400,000 mortgage, but let’s also say that you have $50,000 saved up that you want to invest in shares. Your first option is to put your savings into the share market and invest as you normally would.
The second option, is debt recycling. In other words, using your savings to pay off $50,000 of your home loan and then redraw that $50,000 back out to use to invest in the share market. With both options, your mortgage is still $400,000, but with debt recycling, you can get the added benefit of a tax deduction. Although debt recycling is typically more effective when the interest rates are higher or when your tax bracket is higher, as you’ll save more on taxes, even when rates are low it can still be smart and powerful strategy for earners of any level.
How does debt recycling help me save on taxes?
Normally, interest paid on your home loan is not tax deductible. However, by recycling your debt, you can now claim the interest on that $50,000 as a tax deduction against your investment income (providing that the money was used to purchase an investment). This is because once you redraw the $50,000 out of your mortgage, the purpose of that $50,000 portion of your mortgage went from being private use (mortgage on your home) to investment use. The important note here is that the net result of your finances is the same – you’re not taking on additional debt, like the misconception about debt recycling would lead you to believe – but your taxes are lowered.
This tax deduction saves you money on your taxes and, ultimately, puts more money in your pocket. You could then use those tax savings to pay off your mortgage faster or to further invest in the share market – it’s completely your choice! If you do choose to invest those tax savings into the share market, make sure to use the same recycling strategy to maximise your annual tax deductions.
Do I have to refinance before I can use debt recycling?
Another common misconception about debt recycling is that you have to refinance and structure your mortgage in a certain way, but you don’t have to. The only real requirement is that you can accurately determine (and prove to the ATO) how much of your interest you can claim as a tax deduction. If you invested your money in one lump sum, this may be fairly straightforward to do. However, if there are a lot of small transactions going in and out of your mortgage, things can get messy very quickly, and your accountant might not be very happy with you.
What should I do before I start debt recycling?
What is important is that you understand the features of your mortgage and whether you can recycle your debt. First of all, check whether your current mortgage allows you to redraw and, if so, what those limitations are. Some mortgages only allow you to redraw $1,000 at a time or $1,000 a day, for example, and those limits will inform your debt recycling strategy as well as how best to structure your home loan.
Secondly, make sure you’re communicating with your mortgage broker and your accountant well before you start debt recycling. Your accountant can help you make sure that the way you’re planning on recycling your debt won’t make the books a nightmare for them or cause them to raise their fees.
Your bank or mortgage broker can ensure that you understand the features and limitations of your home loan. For example, some basic loans may not let you split the loan so that the investment portion is interest-only. Some banks they may charge you a higher interest rate on the portion that is used for investment purposes while others have a more generous cash out policy. Because of these differences, you may find it worthwhile refinancing your home loan or switching to a different product before you start debt recycling.
At the end of the day, it’s your choice whether you choose to recycle your debt or simply invest your savings. So long as you don’t let the misinformation fool you into taking on more debt and you get professional advice upfront, you will be well positioned to make the investment decision that’s right for you and your family.