Need to Know | Debt Recycling – What’s it all about?

Candice: [00:00:10] Hello and welcome to Talk Money to me. This is your Need to Know Financial podcast. Thanks for joining us. I'm Candice Bourke.

Felicity: [00:00:17] And I'm Felicity Thomas. Now, in this episode, we wanted to share our knowledge of the financial investment strategy of debt recycling. Now you're probably thinking, what on earth is debt recycling? Well, if you own your own home, you're main residence, right? With some debt on it and you're keen to actually get into the market, you can actually use borrowed funds to invest in the share market. And this episode is going to deep dive on how exactly you do it and how it's going to benefit you. 

Candice: [00:00:46] That's right. So strap in, guys. This is going to be a really exciting episode where we hope you get some really insightful key tips about debt recycling and how it works. Because we find that a lot of investors don't really understand this topic and how it can really benefit you in growing and diversifying your wealth over the long term. Right. Particularly here in Australia, we fall in love with property. It's our lumps, most likely the biggest asset we'll probably ever own. But, you know, we can't do much with it. It's locked away, right? So debt recycling is where you can literally unlock the equity potentially and recycle that into the markets, like Felicity said. Another way to generate your wealth right now, this strategy, we personally both do flats, you know. But good reminder, guys. The information we chat about on our show is not considered personal advice, even though we are registered financial advisors at sharing partners. So please note that the podcast and the content discussed does not constitute a financial advice, nor is it a financial product. So with that, let's deep dive into the topic for today. Felicity, break it down for us. What is debt recycling all about? 

Felicity: [00:01:51] Okay. So debt recycling is a strategy which actually aims to turn your current non-deductible home loan debt into tax deductible investment loan debt. So this involves actually paying down your mortgage and borrowing that money to invest. Hence the word recycling. So you're kind of going full circle now in this way, you do end up with a higher return on your investment because you're actually taxed less and now you have a tax deduction that you wouldn't have had before. So like you mentioned, Candace, we actually use this strategy ourselves and we also use it with clients to help them build their wealth while they continue to pay off their home mortgage, slash their non-deductible debt. 

Candice: [00:02:34] That's right. So another way to think about it, I'm just going to break it down one more time for you is effectively what you're doing is you taking the equity or the funds out of your land, locked up, asset being your home, and then you're investing that into the share market. And what you're trying to do here is you're trying to achieve income or capital growth or both or just growth. Right. So you're taking the money out of your property. You're putting it into a separate set up account, which we're going to go through in order to pull out that money and then put that into the share market. So if you just visualise your house, money comes out of your house, goes into an account, it comes out of there and it goes into the share market, and then it goes up, up, up, up, up. Right. That's that's what we want.

Felicity: [00:03:12] I'll just break it down even a little bit further. You take the money you're going to put in the share market. Right. Pay down your home loan instead. Make sure that you have a redraw facility. Pull the money back out and invest it. So in doing that, you're actually making that portion of the loan tax deductible. 

Candice: [00:03:31] Correct. And then let's assume to also break it down for everyone, Felicity. Let's assume the rates are in half percent. Right. So I think a realistic goal would be doing all that makes sense if you achieve 5% because you've beaten your interest rate and then over time you can decide six monthly, 12 monthly, you take the profits gains or dividends earned and you sweep the funds back into the redraw facility, back into your mortgage.

Felicity: [00:03:56] That's it. And I think what you need to consider here is you probably only want to do it every 12 months, because if you're taking capital gains, you need to take into consideration the tax on the CGT, which, you know, in Australia, if you've held a position for more than 12 months in your own personal name, you actually get a 50% discount on that CGT.

Candice: [00:04:18] Alright, so to help you even further guys, because it is a bit of a complex strategy, let's go into a real life example of what Felicity does. So Felicity, talk us through exactly what you've set up for your main residence. 

Felicity: [00:04:31] Okay. So what I actually set up when I bought my place in 2019, which is my main residence now, I actually asked to split my loans. So assume my loan is $1 million. I actually split it into three different pots. Now, the reason I did that at the get go, it's I didn't want to have to do it once my loan was already set up. However, please keep in mind that you can actually do it now, even if you've got a main residence. So let's assume my $1 million. I've split $100,000 off it, and that's actually what I want to put into the market. I've got $100,000 cash sitting in my offset account. What I've actually done is I've taken that $100,000 cash, put it on to my $100,000, I guess, split loan. I've asked my bank to change it from principal and interest to interest only as well, guys. So make sure that you do that because that's super important. I don't actually want to be paying principal off my investment loan. I've then pulled out that $100,000, ensuring that I do have redraw available. Again, most banks do, but I would double check because you don't want to be with the one bank that doesn't allow you to do that. I have then taken my $100,000 and actually put it in a portfolio that is actually a little bit more defensive than my typical investment strategy. Now, the reason is I actually want to generate dividends, so I've got a little bit more of a bluechip portfolio here. Don't get me wrong, I'm not 100% blue chip. I would never do that. But I do actually have a majority that, you know, growth companies that do pay a dividend. Now every six months you generally get paid a dividend and then every year I take those that dividend income and actually pay it down off my main residence. Now you can do that every year, right? And to you've actually built up a large enough position to then split the loan again. So in my case, I told you I split my loan into three, right? So my third split is another 100,000. So I've actually been paying off that portion. Right. It's not ready to actually pull out and invest in the market just yet because I haven't paid down enough. And for me, really, you want to be able to pull out a larger sum. But that's kind of how it works. You know, in my case. So really, I'm actually paying down my main resident's non-deductible debt. I've now got a deductible debt of 100,000. In an income producing investment. 

Candice: [00:06:59] That's awesome. And it really comes back to a couple of episodes ago when we deep dive guys into why seeking a mortgage broker could be beneficial. And I think the big key message for Felicity's personal experience here on debt recycling is set up the right structure at the get go when you're looking to buy your main residence. Right. And then all the while, this strategy behind the scenes, what's actually happening is you hope that your property price is slowly going up in value over the longer term. So you're building money in the markets and also your properties going up in value, right?

Felicity: [00:07:31] That's it. And look, I think the main goal to wrap your head around with regards to debt recycling, you're probably thinking, oh, great, but I still have debt at the end of the day. Yes, you do. But the whole point is to basically have your entire main residence as a tax deductible investment loan. So it's actually making your money work harder for you and then you can use your portfolio to actually pay off that loan down the track. Now, this is only a good idea if you are a long term investor, do not even think about it if you only want to invest for 12 months. We're talking about a 7 to 10 year time horizon here. 

Candice: [00:08:06] Definitely. And I think it's also important to note that so Felicity in this example is investing in, you know, a bit more safer investments that do have a more of a predictable and reliable income. But what about franking credits? Do they count towards paying down your debt? 

Felicity: [00:08:21] Well, they just helps to reduce your tax rate. So, you know, you definitely want to be invested in companies that are fully franked, if you can. But I wouldn't be choosing your whole investment portfolio over that. I think they also need to look at its own. You know, this probably sounds amazing. It's all sunshine lollipops, right? This is great. But I think you need to also consider that, you know, it is kind of a complex strategy. You know, it is great to build your wealth over time, but it's not for everyone. You know, you need to be comfortable investing long term as well as realising that you are actually continuing to leverage, you know. So you need to understand that the market is quite volatile. So, you know, you're not always going to be in a better position, you know, in the short term. 

Candice: [00:09:07] So to Felicity's point, it is not all sunshine and rainbows. There's a lot more, I guess, aspects to this strategy. We will go through a couple of questions we think are maybe essential if this has sparked your interest to speak to your financial advisor and you know, think about is debt recycling applicable to you and your family in your situation? We're also going to go through a couple of risks associated with this. But before we do all of that, we'll just take a quick break to hear from our sponsors. And we're back. Alright, so he is a couple of questions to think about to potentially ask your financial advisor if, you know, debt recycling might be suitable for you. So is your current home loan already set up for debt recycling? Can you read your funds out? Do you have a separate offset account for investment opportunities? You know, even more broadly, like what's the current interest rate environment doing right now? And might this be a worthwhile time for you and your advisor to see if you should refinance and maybe start debt recycling? So there's just a couple of questions to hopefully spark your interest. 

Felicity: [00:10:11] And I think you do want to also make sure that you do keep things really separate, right? So keep your main residence offset and loan separate from your investment loan and offset account and makes it a hell of a lot easier for your accountant every year. And we do really recommend that you don't try do this on your own unless you're very confident in this strategy that you do seek advice from a registered financial advisor and speak with a mortgage broker as well who's actually done this before 100%. 

Candice: [00:10:41] Because what we're essentially saying is that say your equity in your home has increased. After doing all that by another 50 grand, you have the option if you want, if it's set up properly to draw out that 50 K and invest further into market, that's it. 

Felicity: [00:10:55] I guess that's even I guess taking it to the next level. Right. So not only are you, you know, you've got your main residence debt, you've actually converted some of that to tax deductible debt. You're actually looking at increasing your debt. So you need to have, I guess, a stomach for being quite leveraged. But you know, most banks won't actually let you do it. And more than 80% of the value, which is good again depends on the person, your lifestyle and your objectives. But if you actually keep repeating this cycle of a future years in a really disciplined manner, it really does. Ultimately, like we said earlier, reduce your non-deductible debt into a, you know, fully tax deductible debt in growth assets that, you know, you have a really nice portfolio for the long term. And so like we did say, the loan facility definitely needs to be separated into separate hubs with the ability to choose between principal and interest and interest only repayments. So definitely speak to a trusted mortgage broker more about these different options. 

Candice: [00:11:59] But remember, nothing comes without risks, right? So debt recycling can lead to compounding losses. That's the biggest risk that we all face when we do put our money into the markets, you know, like we've seen in the last couple of months, the markets can be extremely volatile. So if we don't have the right structure set up and if you're not investing long term, you could see some losses there which you, you know, don't want to see. 

Felicity: [00:12:22] That's it. And you probably don't want to go into 100% speculative high growth here either. That is not where you'd want to put your money even for a long term investment. I think another thing is the interest rates associated with the loan facilities is something to keep in mind because they can often increase over time. We already know that at the moment interest rates are going to look at increasing. You know, what you could do in this scenario is actually consider a fixed rate loan so that, you know, for five years the interest rate is say 3%. 

Candice: [00:12:50] Very good point. I think another point to to bring up on the risks are although you're a growth investor right through and through, you're going to be high growth, you're super assuming we're young because we can't touch it. You're going to be high growth in your share portfolio that's in your own name. This is your home. This is what you don't want to stuff up, right? You don't want to have any issues with, you know, being overexposed. So this is when your financial advisor is hopefully saying, let's dial down your risk and asset allocation super key, right? So we need to water it down even if you really want to be growth, growth, growth. 

Felicity: [00:13:23] That's. 

Candice: [00:13:24] It. We might even say something like, you know, for example, more defensive, maybe 80, 20, right, when you're more comfortable with going way more growth side. So keep that in mind. 

Felicity: [00:13:34] That's it. And I think for this particular strategy, you might have a bit more of a sway towards Australia equities rather than international equities, purely because of the income characteristics that we do get with our listed companies here. You know, I think that you should consider that it is really risky and it is super complex. I know it doesn't sound too complex, but it is quite hard to get set up initially and it doesn't suit all investors because I know a lot of people just want to get their main residence paid down and that's it. But what that has led to is a lot of people have these large lumpy assets in retirement, say a $5 million home, and they're on the aged pension. So by doing this strategy, it actually prevents you having this huge lumpy asset and then not actually having any income in retirement. You know, that's the last thing that you want. 

Candice: [00:14:21] That's a really good point, Felicity. And I just want to also backtrack a little bit because my mind sort of like rethinking about all these different things from debt restructuring. Yeah, all these ideas because we do it and we talk about a lot with our clients. You know, you mentioned a good point. Right. We're in an interest rate environment that's rising in Australia, New Zealand, our neighbours just as aggressively the U.S. are doing it, etc. etc.. So if you're concerned on that, you know, it is an idea to maybe think about locking some of it in. Let's assume you lock in three and a half percent. It doesn't matter where rates go because you've locked it in for 12 months. Then your benchmark, like we said earlier, was you can achieve that 5% comfortably if you wash through the ASX like let's say you got a a bias towards Australian, you know, fully franked kind of defensive blue chip companies with some other defensive assets around there. It's pretty realistic in this market to get four or 5% income yield. That's the income alone, right. That's not talking about your growth. [00:15:16][55.2]

Felicity: [00:15:17] That's it's definitely not including the capital growth there because if you look at say like a balanced portfolio over the long term, you're generally going to achieve around 8% per annum on average, 8 to 9% is what we've historically seen in a diversified portfolio. I think you also need to consider what tax bracket your in, right? So if you're already in the top tax bracket, it's fantastic because your 3% is really only one and a half per cent interest. So you it it will be very specific to your own circumstances. So you probably not only want to speak to a financial adviser, mortgage broker, but also your tax advisor, get them all in the room and work out whether this strategy is right for you. So what I do really think that if you don't mind taking on some extra work in complexity, debt recycling can definitely be a profitable and tax effective strategy. Helping you pay down your main residence while building your wealth a lot faster at the same time.

Candice: [00:16:16] And a parallel conversation for listener I often have with clients, you know, taking out a large loan to purchase a property is insurances. So the final point I think, Felicity, we should really let everyone know about is having enough insurance in place. Right. For what? For the what if worst case scenarios. 

Felicity: [00:16:34] That's it. Always have your back up plan. You know, I think income protection is something that you really want to look at here. And I think it's, again, something that a lot of Australians don't actually have. A lot of Australians are underinsured. So income protection is something that will actually pay out if you're injured or ill for a period of time. You know, you ensure your car, your house, but you need to you know, you don't really ensure the most important thing ever, which is yourself and your income. 

Candice: [00:17:01] Alright guys, so we hope you took something valuable out of today's conversation, but to give you a bit of a run through in The Wrap, Felicity, we went through what exactly debt cycling means and that picture, right, that we all try to put in our head. 

Felicity: [00:17:14] That's it. Let's try paint the picture. So we have your main resident's home loan, which is not tax deductible. You then have your offset account offsetting that loan. You then decide to split it and have your line of credit. Let's just assume $100,000. You have an offset account there. You change that loan to interest only. You take your cash from your main residence, offset, pay off that line of credit, pull it out and put it in the share market, and then use that income from dividends most likely every year to then pay off the home loan that is not tax deductible and yes, go through the splitting process. Once again, I hope that kind of painted a picture. 

Candice: [00:17:57] It's a big picture. You need like a big A3 piece of paper, right? So you can draw it out in mind, map it. 

Felicity: [00:18:03] If only everyone could see my hands going, drawing everything. Right? Yeah. 

Candice: [00:18:07] We're very animated because we get excited about these types of topics. And then the other point I guess to remember are there are risks. It's not all rainbows and Sunshine's with this strategy. Make sure you speak to your financial advisor. We've got a couple of those questions. You know, to probe the conversation, if you don't have a mortgage broker, get one look for one. If you don't have a financial advisor, look up the registry, find one and also a tax accountant. Right. Because this can be great if you have all those stakeholders working together for you, it could really change your financial plan around. 

Felicity: [00:18:40] That's it. And look, don't think that you have to start with a large amount. You could probably start with a minimum of around $20,000. I think that's what the banks like to say for your first initial split. And you don't need to do it in chunks. You can actually do it as a monthly debt recycling strategy. It's just a lot more work. So I personally wouldn't do it.

Candice: [00:19:00] So that's a deep dive into the world of debt recycling in about 20 minutes. So that was a massive crash course for everyone listening today on our show. But there's probably a lot more questions that has really come to your forefront, which we're happy to answer as always. So as a reminder, our inbox details TMT am at Equity Mates dot com and we also have an Instagram page where we often will get back to followers questions and the Instagram handle is at Talk Money to Me podcast. 

Felicity: [00:19:29] That's it. Follow us and give us some five star reviews on Apple Podcasts and on Spotify. But before we sign off, please remember that all the Candace and I are financial advisors at Shaw Partners. Please note our discussion today does not constitute personal financial advice. As always, and in particular with this strategy, please seek professional financial advice to see if it's appropriate for you before making any financial or investment decisions. Because this is quite a big one.