Debt Recycling

Today many people seem to borrow money or use built-up equity to purchase depreciating assets such as vehicles, plasmas and so on. This is an inefficient use of debt as these types of assets decline in value over time. Additionally, these types of assets have associated costs such as insurance and maintenance which further erode a household's cash flow. All of these factors have a negative impact on the ability to create long-term wealth.

Rather than using debt that has been repaid on your mortgage for these depreciating assets, it is possible to allocate the debt to appreciating assets such as shares, managed funds or even other property.

The first step is to basically get cash flow under control. By structuring a budget that details inflows (such as income) and outflows (mortgage, utilities etc), it is possible to determine any surplus that may exist. Of course, if there is a deficit then this will need to be addressed with an appropriate restructuring of household finances.

Surplus income can be directed towards reducing the mortgage. This is basically a risk-free return on investment. This is because the investment return needed to earn the equivalent return is always higher than the home loan interest rate. For example, if the home loan interest rate is 7.5%, then it would be necessary for an individual paying tax at 41.5% to earn an investment return of 12.82% to match the strategy of reducing the mortgage. To earn this return would require the investor to assume a higher degree of investment risk.

There are other methods to reduce the mortgage quicker and these include:

• Increasing the frequency of repayments
• increasing the repayment amount with surplus
• Crediting salary directly to the mortgage account
• Using credit cards to pay expenses thus leaving savings in an offset or line-of-credit facility longer

When these methods are combined with using surplus income to pay off the mortgage the potential to reduce the term of the home loan as well as the total payments is increased.

Strategy	Interest	Loan Term
No debt reduction strategy (current debt structure)	$118,619	15 years
Increase frequency of home loan repayments from monthly to fortnightly	$118,125	15 years
Increase loan repayments by $40 per fortnight	$106,585	13.7 years
Salary is credited directly to home loan/offset account	$37,250	5.1 years
70% of living expenses paid by credit card and repaid within interest free period	$36,163	5 years
Saving	$82,456	10 years

Outstanding mortgage is $181,000 · Interest rate is 7.37% · Repayments are $1,665 per month




Once cash flow and the mortgage is under control it is then possible to turn to a debt-recycling strategy as mentioned above. Basically this strategy involves using the built-up equity in the home to purchase assets capable of producing a return with tax savings and no ownership costs.

The first step involves determining what level of debt is comfortable for the investor. A maximum of 80% is recommended as this negates the need for any mortgage insurance. So if the home was valued at $380,000 then the maximum level of debt that the portfolio would ever assume is $304,000.

The second step involves borrowing up to this amount so it is necessary to have equity in the home. For example, continuing with the example, if the outstanding home loan was $181,000 then the initial borrowing for investment would be $304,000 minus $181,000 or $123,000.

The third step would be to invest this amount into something - whether it is direct shares, managed funds or another property. The sharemarket would be a good start as it gives diversification to the existing property. The interest payable on this borrowed $123,000 is now fully tax deductible.

The fourth step is to use the mortgage minimization techniques outlined earlier to rapidly pay down the mortgage over the next 12 months.

The fifth step involves reborrowing what was paid off the mortgage over that 12 month period to add to the investment portfolio. So if the mortgage was reduced by $26,000 to $155,000 then a further $26,000 would be added to the investment portfolio.

The result is that the undeductible mortgage is slowly being converted into deductible investment debt. Additionally, an investment portfolio is being established sooner rather than later. That is, by using this strategy a homeowner need not wait until the home is fully paid off being starting the wealth accumulation process. Obviously this gives the power of compounding much more time to grow the portfolio.

Interest rate is 7.67% · Income is $55,000 and $35,000 with investments held by higher earner · Returns are 4% growth and 3% income · Franking is 70%


Obviously, doing nothing results in the home being paid over the full 15 years remaining on the mortgage. There is no potential for any wealth accumulation as there is no cashflow management at all. Repaying the mortgage using the mortgage acceleration strategies listed above and then investing results in a far superior result. By applying the debt recycling strategy the final amount of the portfolio is higher still although the home loan did take slightly longer to pay out.

	Do nothing	No Recycling	Recycling
Debt Reduction
Total home and other loan term	15 years	5 years	5.8 years
Total home and other loan interest	$118,619	$36,163	$42,071
Wealth Creation
Investment value (net of CGT)	$0	$675,184	$1,025,773
Total investment loan	$0	$0	$304,000
Investment value (net of CGT & loans)	$0	$675,184	$721,773
Benefit of Debt Recycling over each strategy	$721,773	$46,589

This article is general in nature only and is not intended to be financial advice. It is simply an illustration using reasonable assumptions of what a particular strategy may achieve. You should always seek professional advice before making any financial decisions.

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