We all know recycling is good for the environment but is recycling debt good for your finances? In part 1 of this article I’m going to give an introduction into what debt recycling is; some of the risks involved; as well as controls for those risks. In part 2 of the article I’ll discuss the model that I’ve used in more detail to illustrate the how the household cash flows work.
What is debt recycling?
Debt recycling is an arrangement which involves transforming your non-deductible debt (mortgage) into deductible debt (investment loan). It involves borrowing against the family home to purchase income and/or growth producing assets. In the scenario where a household wants to maintain overall debt levels, they will continue to pay off their mortgage whilst simultaneously drawing the same amount of deductible debt to invest in their portfolio.
What makes the debt deductible?
In Australia, when it comes to deciding whether or not debt is tax deductible, what the debt is used to purchase is more than important what the debt is secured against. In this case, because the debt is used to purchase assets as opposed to being used for personal consumption you are allowed to claim a deduction (ATO 2019).
Taxation
The amount of income tax owed is defined by the following equation (for the purpose of this example we’ll ignore franking credits):
In the case where shares are purchased the distributions are dividends and the cost of debt is the interest paid on the investment loan. Where the interest is greater than the distributions received the household will receive a tax refund. This reduces the cost of funding of the asset purchases. For example, if an income earner is in the 32.5% marginal tax bracket and receives $2000 worth of unfranked distributions and the cost of interest is $3000 then the tax payable will be:
Since this number is negative the tax income earner will receive a refund of $325.
Example: The debt recycling Dean family*
The Dean family has a $600,000 house with $200,000 outstanding on their mortgage. They take home $7500 per month after tax and can afford to make $2500 per month in principle and interest payments towards their mortgage. To setup a debt recycling arrangement they need to apply for a loan with 100% offset to the value of $200,000 secured against the equity of their home – sometimes this is called splitting their home loan into 2 components. Each month they will continue to put $2500 into their mortgage and draw $2500 from their investment loan to invest in a diversified portfolio. Each month their non-deductible debt (mortgage) will decrease by about $2500 (less mortgage interest) and their deductible debt will increase by $2500 (plus investment loan interest). So essentially, they are ‘recycling’ their non-deductible debt into deductible debt. After they set this arrangement up their loan structure will be as follows:
If they continue under this structure their mortgage and investment loan balances will look like this:
Notice how their mortgage value falls while the investment loan value increases. Something to observe is that the investment loan value reaches its maximum of $200,000 prior to the home loan being paid off. This is because of the fact that the interest on the investment loan is being paid from the investment offset account. I’ll discuss some benefits of doing this in part 2.
Benefits of this arrangement
Time in the market
Since the process of drawing investment loan debt and paying down their mortgage happens simultaneously, the Dean family do not need to wait until their mortgage is paid off to start investing. Under a debt recycling arrangement, they can have more time in the market than they would if they waited until their mortgage is paid off. Having more time in the market allows the effect of compounding to become more significant.
Reduced taxation
As highlighted earlier the costs and interest paid on the Dean family’s investment loan can be deducted from their portfolio distributions to reduce the amount of tax that they are liable for; you cannot do this with a mortgage for your home. This makes debt recycling more tax efficient than reducing your mortgage payments and diverting some of that money towards investing.
Unlocking the equity in their home
As I’ve said earlier, the family home is a quasi-investment. Once paid off the money sits there locked away and can’t be used to generate a passive income. Using the home as security for debt allows the equity in the home be used to generate returns in the market.
Cost effective debt servicing
At the time of writing the interest rates for this type of debt are sitting around 3.89% which is a little higher than an owner-occupier home loan (ING 2020). Securing debt in this manner makes it one of the cheapest forms of finance available. Also, since the investment loan is secured against your house as opposed to shares there are no margin calls.
Risks
Portfolio returns
Debt recycling only leads to favourable outcomes if long term portfolio returns are higher than the cost of the debt. For the Dean family, if the value of investments drops significantly and there is a need for them to sell their assets they can end up in a situation where they owe the bank money. Since the money is secured against the family home the bank has the right to seize the home to clear the debt if servicing terms can’t be met or the debt can’t be refinanced.
Interest rates movements
The cost of debt servicing will move with the interest rate. This adds an uncontrollable variable to the household cash flow equation as well as overall portfolio returns. In addition to this, interest rates for an investment loan of this sort are usually a little higher than the mortgage interest rate, for the FFE house it is about 0.3% higher. This slightly higher debt servicing requirement will have negative effect on surplus cash flow or portfolio growth depending which cash flow stream is used to service the interest repayments.
Reduced surplus cash flow
When interest rate payments are higher than the income generated by their investments the Dean family may have to service the loan out of pocket. This will have negative effect on surplus cash flow. This is especially true during the earlier years when the effect of compounding isn’t significant.
Irrational investor behaviour
Irrational investor behaviour poses a risk when managing any portfolio, however the leveraged case demands more consideration. Consider the scenario where you own an unlevered portfolio of $500,000 and the market falls by 40% over a course of 1 year. This means your portfolio value eventually drops to $300,000, which is a loss of $200,000 overall; or an average loss of over $16,000 per month, this movement creates huge temptation for investors to sell their investments in order to ‘cut their losses’ – or more so stop the pain. Now imagine how much stronger the pressure would be if that same $500,000 portfolio was made up of $250,000 equity and $250,000 debt with a 6% interest rate. With the same asset price movement your portfolio equity is now only worth $500,000 x (1 – 0.4) – $250,000 = $50,000 but on top of that you need to fork out $250,000 x 6% = $15,000 per year to service the debt. So even though the level of this risk if very difficult to quantify, it is a factor that is crucially important when determining investor success.
Controlling Risks
Understand and control your cash flow
I can’t stress this enough, but if you are in a situation where your household does not already have strong surplus cash flow then this strategy is not for you. In my opinion this is the same for all situations where someone wants to take on any sort of debt. Debt can be very dangerous, there will be times when debt servicing costs are in excess of portfolio returns which means that interest payments will compound any strain that your budget is already facing. This is why it is critical that you have a good understanding of your cashflow situation and where you can cut back on expenses or increase income as and when required. It is also important to assess risks and develop controls to help to reduce the consequence and/or likelihood of being in a situation which results in an unfavourable financial situation.
Set limits on debt level
Setting a limit on the debt level gives you some control over the debt servicing costs. Aim to set a maximum debt level such that your household income can service the debt and still maintain an acceptable standard of living if interest rates were to rise substantially.
Another factor to consider when limiting the debt level is your own appetite for risk. Even if the math shows that your household will be able to service the debt it still may be something that you are uncomfortable with. My opinion is if it doesn’t allow you to sleep at night then the possible gains are not going to be worth it.
Invest for the long term
There’s an old saying that goes something like this: “time in the market beats timing the market”. This is especially true when your investments are leveraged. There’s nothing worse than panic selling during a market crash and then having to pay back the bank. When the markets are rising and you are thinking fairly rationally make plans as to what you will do in order ensure that you can continue to invest when the market falls. This way you have a better chance of avoiding fear driven irrational investor behaviour which can destroy your portfolio returns.
Diversify
Debt recycling is very similar to using the equity in your home to purchase another house for investment purposes however I would only recommend using the debt to buy broad based funds. There are many people that have made bulk money by leveraging one property to buy another and another and another but it’s not something I’m personally keen on. Individual asset prices and markets are not something that you have control over so it’s a smart idea to spread the risk over numerous assets and asset classes. I’ve previously talked about how we’ve constructed our portfolio in this article.
Automate investing action
As discussed earlier, investor psychology is huge risk to long term success. One of the best controls for this risk is to create a plan to invest consistently at your target asset allocation and have this process automated. This reduces the need for you to invoke your own decision making which reduces the likelihood that you will make an irrational decision.
House paid off, what happens after?
Fast forward 8 years, at a 7% p.a. portfolio growth rate, the Dean family finances look something like this:
| Investment portfolio | $244,198 |
| Mortgage | $0 |
| Investment debt | $200,000 |
| Interest paid | $21,198.65 |
After paying off their mortgage the Dean family have a net portfolio position of $44,198. They now have the choice of paying off the investment loan or adding more to their investment fund; either choice will cause their net equity position to increase. At the FFE house, once we reached the point of paying off our mortgage, we chose to keep the loan and continue to add to our investment portfolio. The reason for this is that the longer we can keep the debt the larger the effect of compounding will be in the leveraged part of the portfolio. We intend to keep the loan until we no longer earn an income then use the proceeds from liquidating part of our portfolio to pay off the loan. Because we expect our assets to grow at a higher rate than the debt, in the long run, we expect that the portfolio balance on the leveraged part to be significantly higher than the value of debt.
Wrapping it all up
If you’re still with me BIG HIGH FIVE! To sum it up debt recycling is a structure that allows households to unlock the equity in their home in order to build an investment portfolio while paying down their mortgage. It is worth considering if you have a good handle on your household cash flow situation and are looking to optimize your finances. Here’s a quick recap of the benefits, risks and considerations of going down this path.
Benefits
- Allows a household to build their investment portfolio while paying off their mortgage. This gives their portfolio more time to grow which means they take can better take advantage of compounding.
- Reduced tax on portfolio distributions. The debt servicing costs under this arrangement can be subtracted from the portfolio distributions which reduces the tax liability of the household
- Allows you to be able to produce investment returns using the equity in your home
Risks
- Interest rate movements affect the servicing costs of the debt which are a direct cost to the household. This will affect the overall portfolio return
- Portfolio returns – in general this strategy only works if portfolio returns in the long run are higher than the cost of servicing the debt
- Cash flow volatility – if the debt servicing comes from the household income then this cost will directly affect the cash flow position of the household
Consider carefully before implementing this strategy
- Your surplus cash flow situation and where you can cut expenses or increase income as and when debt servicing costs rise
- The assets and asset classes you are choosing to invest in
- The length of time you can hold your investments for
- Your ability to avoid irrational investor behaviour
There you have it, debt recycling in a rather large nutshell, hopefully this the information has given you some idea of what is involved with this strategy. In the following article I’ll discuss the model used to generate some of the numbers quoted here in more detail.
Engineer your freedom
*The Dean family is a fictitious example for simulation purposes only, any resemblance to people in real life is unintended
References
ATO 2019, Interest, dividend and other investment income deductions, ATO, viewed 14/2/2020 < https://www.ato.gov.au/Individuals/Income-and-deductions/Deductions-you-can-claim/Other-deductions/Interest,-dividend-and-other-investment-income-deductions/>
ING, 2019, ING Home loan interest rates, viewed 14/2/2020, <https://www.ing.com.au/rates-and-fees/home-loan-rates.html>