The strategy that could get you debt free – even with a mortgage

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One of the main tenets of money advice – especially the sort you hear commonly from the financial independence, retire early (FIRE) crowd – is to be debt-free. And it makes sense, as owing lots of money and paying interest are two things that aren’t conducive to being financially independent.

However, while this is sage advice for (comparatively) small debts such as credit cards and car financing, it is much more difficult when it comes to a $500,000 home loan – a large sum most people would consider “good” debt as it helps put a roof over your head.

Debt recycling involves using the equity in your home to invest in income-producing assets.Credit: Michael Howard

But what if you’re really determined to be debt-free, even with a mortgage? Enter debt recycling.

Considered a fairly high-risk strategy, debt recycling involves using the equity in your home to invest in income-producing assets. It also is a way to convert a non-tax-deductible investment (an owner-occupied mortgage) into one that is tax-deductible.

Say you have $300,000 of equity in your home. You withdraw some or all of that and take out an investment loan to buy an income-producing asset such as a rental property or parcel of shares. The interest you pay on that loan is now tax-deductible (as opposed to the non-deductible home loan), and you then use the income from that asset, plus any tax savings, to pay down your mortgage faster.

What’s the problem?

This piece of financial wizardry can be a very effective strategy for savvy investors, but it can quickly fall apart. Leveraging your investments, especially when it involves your family home, can be high-risk, and you can compound your losses if your investments perform poorly, or the market hits a rough patch.

Paul Benson, financial advisor and Money guru, says “careful number crunching” is required for anyone considering this strategy, as it involves a lot of moving parts.

What you can do about it

Here are some other important considerations when thinking about debt recycling:

• Who does it suit? Firstly, a mortgage (with a decent chunk of equity) is essential for a debt-recycling strategy. It’s also best for high-income earners in a higher tax bracket who will be able to gain the most benefit from the tax-deductible loan, explains Vivian Rudra, senior financial advisor at Viridian Advisory. “It is also better suited to those with a stable income and surplus cashflow, to meet the interest costs of the loan and to cover any shortfall between debt servicing costs and income generated from the asset,” Rudra says. A debt recycling strategy is also best done over a 10-year or longer timeframe during which your investment may fluctuate or lose money, so it’s important to have a strong risk tolerance.

• Be sensible about your investments: Owen Raszkiewicz, chief investment officer at Rask Invest and a keen debt recycler himself, says it’s important to invest the right way. Popular options are investment properties, individual shares or ETFs, he says. “Sensibly invest in reliable investments for the long run. Debt recycling to buy things like cryptocurrency would be like waving a big red flag at the ATO as it potentially would not meet the income generating test.”

• Keep an eye on interest rates: While anyone with a mortgage has a keen interest in what the RBA does, it’s doubly important for debt recyclers as rising interest rates can significantly impact the effectiveness of the strategy. “If interest rates rise, the cost of servicing your investment loan could increase, reducing the overall benefit,” Rudra says. Banks charge higher rates for investment loans, so your tax deductions/income have to be high enough to offset this.

• Get advice: If it’s not already obvious, debt recycling is fairly complex, so spending the time and money to get an accountant or licensed adviser to go over it with you is likely worth your while.“[While it] may cost you $4000 to $6000 for a professional financial plan, it’s almost always worth it when using a debt strategy because it can help you avoid costly mistakes,” Raszkiewicz says. “Plus the benefits of getting it right will easily outweigh the out-of-pocket expenses.”

Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.