For most Australians, purchasing a home is one of life’s greatest milestones. Unfortunately, it also marks the beginning of one of life’s biggest debts, often putting the brakes on your wealth accumulation. If you’re keen to start investing in property or shares but feel financially limited by your home loan commitments, debt recycling could be a solution for you.
What is debt recycling?
Debt recycling is a financial strategy which allows you to convert non-tax-deductible home loan debt into tax-deductible investment debt.
With this strategy, you pay down home loan debt (which is not tax-deductible), and re-draw it as an investment loan to acquire property, shares or managed funds, effectively building a portfolio of investments which can grow, compound and tax effectively build your wealth. All additional income generated by your investments (e.g. dividends) is then directed to paying down your home loan.
Is it the right financial strategy for you? The answer depends on your asset to debt ratio
Debt recycling is a smart financial strategy that can be great investment advice. But first you need to understand your balance sheet and know your assets and liabilities.
The right asset to debt ratio is different for everyone, but managing it effectively is the key to your financial success. Debt recycling is most applicable to higher income earners with an ability to pay down more than the minimum home loan repayments each month. However, there is no one-size-fits-all answer to this question. It depends on your financial circumstances and risk appetite.
Seeing debt recycling in action
Consider a home loan of $500,000 with annual interest of 5% and principle and interest repayments of $60,000 p.a. After 1 year, the home loan would be paid down to approximately $465,000 and $35,000 can be re-drawn as a tax-deductible loan and invested into a portfolio of growth investments. As seen in the below chart, the benefits of debt recycling compound over the long term and include a reduction in personal tax, paying down your home loan quicker, while building additional investment assets and an income stream.
What are the risks to choosing debt recycling for property investment?
With debt recycling, you will still have debt (albeit tax-deductible) and your level of risk is increased. Over time, the total amount of debt stays the same, but the nature of the debt changes, allowing more of it to become tax-deductible each year, all while you are growing an investment portfolio for the future. Long term, as you repeat this process, your investment income and capital compound, and your non-deductible home loan debt can be paid off at a faster rate.
Take the next step to build wealth faster
Paying off your home loan doesn’t mean you have to stop building wealth. When managed well, good debt can improve your cash flow and increase your wealth quickly. However, as with any investments, the risks must be properly considered before you make any decisions. A qualified financial adviser can help assess your risk appetite, review your debt position and your current structures and arrangements, explore strategies to reduce bad debt and maximise the value of assets through debt restructuring, diversification and asset management.
Contact your adviser or book in for a free financial health check to find out if this strategy is right for you.
Note: The ‘See debt recycling in action’ chart above assumes a starting home loan of $500,000 with principle and interest repayments of $60,000 p.a. being made at an interest rate of 5% p.a. Income earned from the investment portfolio is at a rate of 4.3% p.a. and this has been allocated toward the repayment of the home loan using this strategy. The investment portfolio has been assumed to grow by 3.59% p.a. Other factors such as higher interest rates and lower investment returns may alter this projection therefore it is important that you consult your FMD adviser to discuss whether this strategy is right for you.
General advice disclaimer: This article has been prepared by FMD Financial and is intended to be a general overview of the subject matter. The information in this article is not intended to be comprehensive and should not be relied upon as such. In preparing this article we have not taken into account the individual objectives or circumstances of any person. Legal, financial and other professional advice should be sought prior to applying the information contained on this article to particular circumstances. FMD Financial, its officers and employees will not be liable for any loss or damage sustained by any person acting in reliance on the information contained on this article. FMD Group Pty Ltd ABN 99 103 115 591 trading as FMD Financial is a Corporate Authorised Representative of FMD Advisory Services Pty Ltd AFSL 232977. The FMD advisers are Authorised Representatives of FMD Advisory Services Pty Ltd AFSL 232977.