In the previous article I talked about what debt recycling is and highlighted some of the benefits and risks associated with this strategy. To demonstrate the effects of household cash flow, portfolio growth and taxation I created a model called “The debt recycling Dean family”. The simulation compares their portfolio growth under the debt recycling scenario with the scenario where they pay off their mortgage completely before they start investing. To model the Dean family’s situation, I used the following assumptions:
| Take Home Income | $90,000 |
| Cost of Living | $60,000 |
| Distribution rate (p.a.) | 2.1% |
| Portfolio growth rate (p.a.) | 7% |
| Mortgage | $200,000 |
| Home loan interest rate | 3.20% |
| Investment loan interest rate | 3.70% |
| Yearly draw down/mortgage repayments | $30,000 |
For taxation purposes I’ve assumed that we are dealing with a dual income household where both parties are in the 32.5% tax bracket and the ownership of the portfolio is 50/50. Also, both parties will continue to work for the full 30-year duration of this simulation.
The Dean family will make monthly mortgage payments at a rate of $30,000/12 = $2500 per month. This will also be the amount that they draw down on their investment loan to invest each month.
The structure
As per the previous article the family home will be used to secure 2 loans: the home loan (non-tax deductible) and the investment loan (tax deductible). Both loans have offset accounts attached to them but the investment loan offset account will start with $200,000 in it – this arrangement is known as a loan with 100% offset. As with all offset accounts this means that interest will only be charged on the balance of the investment loan minus the value of the funds in the offset account. For modelling purposes time period 0 represents the 1st of the month; time period 1 represents the end of the 1st month and all numbers after represent the end of each subsequent month. Mortgage repayments and investment offset account withdrawals are made on the last day of each month after interest is charged.
Cash flows – start of the first month (period 0)
Cash flows – end of the first month (period 1)
Cash flows – end of the second month (period 2)
Cash flows in table format
Here are the cash flows for the mortgage pay-down in table format for the first 12 months:
Here are the cash flows for the investment loan offset account and portfolio in table format for the first 12 months:
Notice how during the second month $7.71 of interest is charged on the balance of the investment loan. For this model, interest is compounded monthly using the following equation:
The investment loan interest can either be paid out of the household excess cash flow; paid from the cash in the investment loan offset account or paid for out of the portfolio. As shown in the cash flow diagram above I would preference paying for the interest out of the cash in the investment loan offset account so that the mortgage pay down time is not affected. Doing so also allows the portfolio to be left alone to grow. However this does result in the investment loan offset account being drawn down to $0 before $200,000 is added to the portfolio. In this example, once the investment loan offset account reaches $0 only about $179,412 will be added to the portfolio and the remaining $20,588 will be interest payments. After this point the interest will either need to be paid out of household cash flow or from the investment portfolio. In the model the interest is paid out of household income however the decision for any household will depend on individual circumstances.
Extrapolating out 30 years
If we extrapolate this out over 30 years the results are as follows:
In this simulation the Dean family’ mortgage is paid off in 7 years and 7 months. What we can also see is that the investment loan is drawn down completely about 18 months before the mortgage is paid off – this is represented by the flat part of the red line between year 6 and 8. As discussed earlier, this is due to the use of the cash in the investment loan offset account being used to fund the investment loan interest payments.
Portfolio Equity positions
This simulation shows that by the time the mortgage is paid off at the end of the 8th year the household’s portfolio value is around $244,198 for a net equity position of $44,198. This essentially gives the debt recycling arrangement a $32,265 “head start” over the case where the mortgage is paid off first. This proves to be very valuable in the long run where we see the respective portfolio values as follows:
Taxation
In this simulation I assumed a 2.1% distribution rate which is about 0.1% higher than the average dividend yield for the S&P 500 from 2009 to 2015 (Ross 2019). I did this to account for the model portfolio having a small percentage of higher yield assets such as REITs. For simplicity I didn’t allow for franking credits and assumed that the dividends are 100% taxable at the marginal tax rate for the 2 household income earners. What this simulation shows is that the household will receive a small tax refund when the investment loan interest rate is greater than the portfolio distributions; this occurs until the 9th year. Something to note is that in the real world this will be highly variable depending on the growth of the portfolio which can vary greatly year to year. Further to this, it is only until the 15th year that the tax bill under the debt recycling arrangement exceeds that of the no debt recycling arrangement.
Illustrating some key risks
Interest rate movement
Let’s examine a possible scenario where in the 10th, 11th and 12th year interest rates increase to 11% when the loan value is at $200,000. This means that the loan will have interest payments of $22,000 per year. Keeping returns at 7% we observe the following changes.
In this scenario because the interest payments ($22,000 p.a.) are less than the household’s excess capacity ($30,000 p.a.) The Dean family are still able to add money to their portfolio, which indicates that there will be no strain on the household cash flow situation.
Under the interest only loan scenario, only once the interest rates exceed 15% will the Dean household have to make changes to their budget or liquidate their portfolio in order to maintain interest rate payments. At 7% p.a. growth rate we see that their portfolio is still able to add $348,826 – $313,849 – $8000 = $26,977 each year.
Servicing costs exceed excess capacity
In the case where the loan servicing costs are higher than the Dean family’s excess capacity, which can happen as a result of interest rate movements and/or increases in cost of living, the Dean family will need to consider taking money out of their portfolio to service the debt. This is an especially undesirable position to be in if the portfolio is making negative returns – times when the market is down are good buying opportunities.
One effective control for this risk is to consider the cases where some sporadic increases in the cost living might occur and limit the amount of debt accordingly. Let’s take the example where the Dean family believes that one year their cost of living may increase to $75,000. This means that their spare capacity will be $15,000, so if servicing costs rise higher than $15,000/$200,000 = 7.5% they will be forced to liquidate part of their portfolio. Now, if they see this risk as unacceptable then they should consider limiting their debt. At $150,000 debt interest rates would need to rise to 10% before they are forced to liquidate.
A taxation consequence of this scenario is that because their interest payments are now higher than their portfolio distributions, they will receive a tax refund which reduces the debt funding costs slightly.
The second control that can be implemented would be to increase excess cash flow by either increasing income and/or decreasing cost of living. However depending on your household situation this may be very difficult to do. As I’ve discussed before, lifestyle inflation is difficult to reverse.
Concluding thoughts
I hope that this simulation has helped to demonstrate how debt recycling can be used to grow a portfolio faster. It is important to understand that the reason why debt recycling outperforms paying off the mortgage first is largely due to 2 factors:
- Debt recycling allows the household more time in the market to take advantage of compounding. This means that for best chance of success a household needs to have excellent control over their cash flow in order to invest consistently
- The portfolio growth rate is higher than the interest rate. Personally, I believe that the market risk premium does exist which implies that in the long run, overall lending costs will be lower than investment returns. However, in the short term there will be times when lending costs do exceed market returns so to have the best chance of making this statement correct an investor needs to invest consistently for a long period of time.
Once again, even though this strategy can be considered low risk relative to many other leveraging methods it will still increase the complexity of your household finances as well as impact your cash flow situation. I would recommend speaking to a financial planning professional to get advice that is specific to your situation before implementing this strategy.
If you are interested in looking at how I’ve generated the numbers you can download the spreadsheet that I created for this article here.
Engineer your freedom
References
Ross, S, 2019, A History of the S&P 500 Dividend Yield, viewed 22/2/2020, <https://www.investopedia.com/articles/markets/071616/history-sp-500-dividend-yield.asp>