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What Is Debt Recycling, and How Can It Help You Better Manage Your Money?
Welcome to POPSUGAR Powerhouse, a content series that aims to hand you the keys to financial freedom and take control of your money in 2022. Our goal is to fill you with the confidence and know-how to make your money dreams come true.
We’ll give you expert advice and information curated, covering topics including a first home buyer’s guide to property, getting started with investing, debt recycling, and much more. You can find all of the POPSUGAR Powerhouse stories here.
Recycling is a topic that most of us are familiar with. From a young age, we are taught to recycle paper and plastic around the home. We recycle our old phones and furniture, and we can even recycle our old socks. But, did you know that the concept of recycling can also apply to your finances?
Debt recycling is a strategy that is getting more attention with the rise of social media and online investment forums, as people share their strategies and secrets for success. However, along the way, there is also some confusion that can arise about what exactly it is and how it works.
This quick guide will arm you with the tools and information you need to understand debt recycling and assess whether it is right for you.
What Is Debt Recycling?
Put simply — debt recycling means not using your savings to invest. It is a strategy that typically applies to homeowners who haven’t paid out their mortgage yet and want to invest more tax effectively. In this instance, rather than making regular payments on your mortgage and using your savings to invest, you would instead use your savings to pay down your mortgage and then redraw that amount again and use it to invest.
Let’s say you have a $400,000 mortgage, and have saved up $50,000 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 by deploying debt recycling, interest on $50,000 of your mortgage is now tax deductible.
If I Increase My Mortgage to Invest, Is That Also Debt Recycling?
In short — no. Although it is a common misconception. Many 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. That is simply borrowing to invest and using your home to secure the loan. Strictly speaking, the term ‘debt recycling’ refers purely to the act of converting a non-tax deductible debt into a tax deductible one.
What Is the Benefit of Debt Recycling?
The ultimate benefit of debt recycling is reducing the amount of tax you pay each year. The less tax you pay, the more money you have to put towards growing your wealth. This is because normally interest paid on your home loan is not tax deductible.
However, by recycling your debt, you can now claim the interest on the redrawn amount as a tax deduction against your investment income (providing that the money was used to purchase an investment). This is because once you redraw those funds out of your mortgage, the purpose of that 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 in the process.
What Should I Do Before I Start Debt Recycling?
Before you start debt recycling it is important that you structure your home loan in such a way to make it as easy as possible for you to manage your investments and claim your tax deduction.
Start by speaking with your accountant, financial planner and mortgage broker well before you begin debt recycling. Doing so will enable you to make the most of it:
- Your accountant can advise you on the best way to set up your mortgage and investments to make claiming tax deductions a breeze.
- 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 and redraw 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.
- Your financial planner can make sure that you are adequately insured and the investments are aligned with your overall strategy.
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.
Natasha Janssens is a Certified Money Coach (CMC)® and founder of Women with Cents. She is an award winning financial educator with a passion for supporting women to transform their relationship with money. If you don’t know what you don’t know when it comes to money and financial matters, her book Wonder Woman’s Guide to Money is for you. For more of Natasha’s tips follow her on Instagram and take the Money Type Quiz.