What Is Debt recycling?
Debt recycling is the process of growing wealth by finding smarter uses for your existing resources, like a home with a mortgage. By being smarter with how your income connects with your debt, such as how you pay the mortgage on your home, you can grow your personal wealth – all with the blessing of the tax office.
Good debt vs bad debt:
In the eyes of the Australian Tax Office (ATO) there are two types of debt. They see them as 'good' and 'bad'.
Bad debt is something like the mortgage on your home. While having somewhere to live is important, the ATO doesn't let you claim the interest you pay on this mortgage as a tax deduction.
Good debt is when the borrowed money is used to buy investments which help increase your income and wealth. The ATO sees this as good debt because you are investing to help grow the economy.
Examples of 'good' investments are shares, managed funds, property (not your home) etc. The ATO rewards you for helping the economy grow by letting you claim a tax deduction on the interest expenses of the borrowed money used to buy these investments - like the interest payments you’d make for an investment property mortgage.
Recycling process: The recycling process starts by using the ‘bad’ debt on your home.
As you pay down the mortgage on your home, you use the portion of the home that you own (the equity) to start investing. Many people have this equity as cash in their 'offset account'.
Because the money coming from the offset account is borrowed money, you are effectively creating an investment loan; which is 'good debt', because it’s tax deductible.
To complete the recycling process, you use the income from these investments to pay down the mortgage on your home.
This increases the equity you have in the home, which you can draw down on once again, to increase your good debt and invest more.
In turn, this creates more tax deductions, and speeds up how quickly you can pay down the mortgage.
The idea is that eventually the ‘bad’ debt in your mortgage has been replaced by ‘good’ debt – making it all tax deductible – and now you have an income stream on the side of your mortgage.
The Pros and Cons of Debt Recycling: As with all investing, there are always benefits, the ‘pros’, and risks, the ‘cons’.
The good parts of debt recycling are that if it is structured correctly it means that:
- Effectively the ATO is helping you grow your wealth through tax advantages - Investing can start today, while paying off your mortgage, even with a small amount - You’re kick-starting your wealth through an investment portfolio and using the income from these investments to reduce your bad debt - The higher your income, the more effective this strategy is – think of it like a snowball at the top of a hill.
The bad parts of debt recycling are that:
- Borrowed investments can go down as well as up - No investment return is ever guaranteed - You need to be comfortable with the notion of changes in investment values, just as share prices do go up and down - The strategy is dependent on you having an income stream (job/salary etc.) - It’s a long-term investment horizon, not a quick money grab. This snowball takes time to gain momentum, but after a while, it kicks up the gears - The higher your income, the more effective this strategy is. Lower income earners have a steeper hill to climb to start the momentum – but it will still take off eventually
Why does the ATO allow this: While we can’t speak for the ATO, these tax concessions help promote your wealth accumulation. Helping you create more income/wealth is good for the balance sheet of the country, increasing prosperity and GDP - and it also makes it less likely they’ll need to support you (via welfare) in your old age.
We support the ATO's decision to help Australians achieve their lifestyle goals - just ensure you get appropriate advice to see if this strategy is right for you - and critically, it must be set up correctly. This is a detail-orientated strategy, and the ducks all need to be lined up before you start ‘shooting’.
Whether this strategy is for you or not, congratulate yourself on researching wealth creation and getting one step closer to increasing your own personal wealth.