What is debt recycling?

Debt recycling can be a way to pay off your home loan more quickly while accumulating a portfolio of income-generating assets, but if you are considering this strategy, there are some key risks to keep in mind and things to be aware of.

What does debt recycling mean?

Debt recycling is a strategy that can be used by homeowners to pay off their home loans as quickly as possible, while building up long-term wealth in a way that is advantageous for tax. It involves replacing or ‘recycling’ the non-tax deductible debt on a home loan with tax deductible debt from investments.

How does debt recycling work?

The process of debt recycling involves taking the equity that you have in your property (the difference between the value of your home and how much you still owe on your mortgage), and investing it in income-producing assets that have the potential for growth. These income-producing assets could be any number of things, but examples of income-producing assets include shares, exchange traded funds (ETFs) and investment properties.

Once you have purchased these assets using your home equity, the earnings you make from them can be used to make repayments on your home loan, potentially allowing you to pay it off more quickly than you otherwise would have been able to. According to AMP, the interest on investment home loans is also tax deductible, and using this strategy could potentially create a tax saving, allowing you to put more money towards paying off your home.

What are the potential advantages of debt recycling?

There are a number of ways in which a debt recycling strategy could be financially beneficial, including by potentially helping you repay your home loan more quickly, diversify your investment portfolio and earn passive income.

The potential to pay off your home loan more quickly

The assets that you purchase using the equity in your home have the potential to generate earnings, and if you do earn a profit from your investments, this profit can be put towards paying off the balance of your home loan. The more of your home loan you have paid off, the more equity you will potentially have in your home, which can in turn mean the more investment assets you can potentially purchase.

The potential to diversify your investment portfolio

Diversification is a tool that investors can use to help mitigate risk and generate returns across a variety of assets. Diversifying means, in effect, that you are not putting ‘all your eggs in one basket’ when it comes to investments. If you decide to employ a debt recycling strategy, you could potentially fund the purchase of assets from a variety of different classes, such as those mentioned above, creating more balance in your portfolio.

The potential to earn a passive income

Over time, the investments you purchase via debt recycling could make profits, and could even allow you to earn a passive income, such as rental returns from an investment property, or dividends from stocks or EFTs. Keep in mind you can both make money and lose money through investing, and past performance isn’t a reliable indicator for the future performance of investments.

Is debt recycling risky?

While debt recycling may allow you to build wealth and repay your home loan more quickly, it is important to keep in mind that it is still a potentially risky strategy, and you are borrowing money to invest. If you are considering debt recycling, some important things to keep in mind include investment income fluctuating and potential for interest rates to go up.

The potential for investment income to fluctuate

It is important to keep in mind that investments do not guarantee you an income. If the market takes a downturn or your investments do not perform as well as expected, you will still need to repay your investment loan. It is important to consider your financial position and whether you will be able to service your loans, should your investments not perform or your assets take a fall in value over time.

The potential for interest rates to go up

Generally speaking, variable rate home loans come with features such as the ability to pay off the balance of your home loan more quickly, and use an offset account to minimise your interest repayments. Such features would potentially be useful for a homeowner employing a debt recycling strategy; however, it is important to keep in mind that if your variable rate goes up, you will end up paying more in interest over time. You should consider  factoring potential interest rate rises into your budget.

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