Author & Founder
So you want to start investing, but you also have a home loan.
You want to start making big money moves and see your wealth grow.
But at the same time, you sense you should focus on paying off your mortgage and free yourself from its wrath.
Well, I’ve got good news for you….
You can do both.
Start investing, and keep paying down your home loan. And I don’t mean splitting your surplus savings in half and putting some on your mortgage and some in your money machine.
I mean putting it all on your mortgage and all in your money machine.
Sounds like a magic trick, right?
Most financial advisors will charge you crazy amounts to perform this magic. Often up to $6,000 to advise you on how it works and then implement it for you. And then will likely charge you $3.5-5k per year to help you ‘manage’ it.
Which adds up to tens of thousands of dollars.
In this post I’ll pull back the curtain on this big money move, so you’ll have everything you need to get it going yourself. It’s a controversial comment, but I suspect that if you can tick all the boxes in this guide, you’ll have a better understanding than most traditional financial advisors. Meaning, you can be confident in your approach and keep the returns that are rightfully yours.
Which could be hundreds of thousands of dollars.
What is it exactly?
It’s not a magic trick.
It’s not a get-rich-quick scheme either.
Instead, it’s a proven strategy for building wealth.
But it’s been kept a secret behind the doors of the ‘professionals’, which is why I’m writing this post. I couldn’t find any resources on the internet that explains it well enough. The only resources I could find was FIRE bloggers attempting to justify their position of using, or not using, this strategy.
Let’s get to it.
It’s called ‘Debt Recycling’.
And it’s a process of slowly converting your mortgage into an investment loan, all while building your investment portfolio and earning passive income.
You channel all your surplus cashflow into repaying your mortgage, and each time you repay your mortgage, you increase your investment loan at the same rate. Then, you use this new borrowed money to buy investments that pay you income.
That’s the most basic explanation of debt recycling you’ll ever read.
I promise I’ll explain it properly shortly.
But first we should consider why it’s worthwhile.
Why should someone do it?
There’s a few key rewards of this big money move:
💸 Pay off your home loan quicker
💸 Save on taxes over your lifetime
💸 Start investing sooner, making ‘time’ your ally by gaining years of compounding
💸 Earn passive income
But let me be clear – debt recycling isn’t for everybody. There’s certain criteria you’ll need to meet before taking this on for yourself. This is what you’ll need:
1️⃣ A home
2️⃣ A mortgage
3️⃣ Cashflow surplus (aka “ability to save”)
4️⃣ Productive equity
Okay, most of these are pretty self-explanatory, except for one. What is this jargon bulls^*t ‘productive equity’?
Let me explain…
In language you’ll be familiar with from chatting to your banker or mortgage broker, your home is split up in 2 parts: your mortgage and your equity. Mortgage being the loan that must be repaid, and equity being the property value less the mortgage.
But to understand ‘productive equity’ in terms of debt recycling, we need to break equity down into 4 smaller pieces. I call these ‘equity elements’.
Equity Element #1: The Roof
Makes sure you have, and continue to have, a roof over your head.
Makes sure you have, and continue to have, a roof over your head.
Equity Element #2: The Ceiling
Provides you with comfort, so you don’t have to listen to hail on the tin roof in winter or melt in the sweltering heat in summer.
Equity Element #3: Productive Equity
Helps you build your wealth, so you don’t have to rely on your savings capacity to invest.
Equity Element #4: Mortgage
Gives you a home to live in that you couldn’t otherwise afford to own.
Now that we know what the equity elements are and what they do, let’s look at general principles about how much of your equity should be allocated to each element.
Important: Keep a margin of safety!
Firstly, do not ever touch your roof.
A single hole can lead to all sorts of damage, and is something you’d rather not experience. Hopefully when you bought your home, you mastered saving first and put down a 20% deposit.
You started with a roof.
Your ceiling, at 10%, is an extra layer that provides you with comfort and peace of mind.
The reality is, every market experiences volatility. And while our home is rarely valued, it does go up and down in value more than any other asset – think about if you held an auction at your house every single day.
Rain, hail, or sunshine.
The variance in what someone would be willing to pay on any given day would be bloody huge! I’m not saying you’d do this – but it’s important to note that you don’t want to run the risk of having to sell your home on a day other than that of your choosing.
A ceiling dramatically reduces the chances of this happening.
Together, your roof and ceiling make up 30% of your home – which you should keep as untouched equity. Meaning your house would need to fall in value by more than 30% for it to be in the negatives. If you don’t have 30% equity yet, this is your first target.
Your property value x 70% = your mortgage safety target.
As debt recycling focuses on using debt, your best bet is to find the valuation done by your bank when you setup your home loan or last re-financed.
Your bank or mortgage broker will know what your property is valued at.
If it’s been some time, or you believe the valuation is way off, you can request a new valuation (this may cost a small amount). Alternatively, for the sake of running some numbers, you can visit realestate.com.au or similar sites to compare other properties in your area. Some may even value your house automatically to give you a basic estimate.
If you have a ball park in mind, this will do for the exercise to follow.
Your productive equity is any equity beyond the 30% reserved for the roof and ceiling.
Let’s say you’ve paid your mortgage to 60%. This means you have 10% available as productive equity.
Let’s bring this together and use real numbers to paint the picture.
Here’s a home valued at $1,000,000.
To have the minimum margin of safety in this scenario, the mortgage would need to be $700,000 (the property value less the roof and ceiling). This is the minimum number to aim for before starting the debt recycling strategy.
I want to highlight ‘minimum’ in that last sentence.
If you were to enact the above percentages perfectly, some people would call you ‘aggressive’. I don’t mean you get angry for no good reason. I mean you would be a person who uses the minimum margin of safety with your roof and ceiling.
But, you might not be an aggressive person.
Maybe you’re a ‘conservative’ person. As a conservative person you might want a ceiling of 15%, or even 20%, meaning much more would have to go wrong for you to ever be in strife. That’s okay too. Sleeping well at night is priority number one.
If it affects your sleep, don’t do it.
When should you start?
Let’s assume you’ve ticked the first box of having a:
✅ Ability to save
Now, you want to meet the criteria of sufficient ‘productive space’.
Where’s the starting line?
Essentially, it’s as soon as your mortgage is paid down far enough below 70% that you have enough productive space to justify it. For every 1% you go below 70%, you create borrowing capacity (equity) you can use. But it’s a decent process to set up a new loan, and you want that work to be worth it.
So, with the example of a $1,000,000 dollar home:
If you paid it down to 65%, you could set up a $50,000 loan and keep your total debt to 70%.
Or you could pay it down to 60%, allowing you to borrow $100,000 (we’ll walk through this example in a bit).
That’s the numbers-based answer.
But you also need to tick two important boxes.
#1: Are you comfortable investing this way?
If the idea of recycling debt has put your stomach in knots, you likely haven’t taken the time to understand how to invest intelligently. Paradoxically, the best way to get comfortable is to gain experience with investing. But you need to first understand the principles of income investing.
Here’s 3 important resources I’d encourage you to absorb:
- Motivated Money by Peter Thornhill
- How to invest intelligently, Part 1 & Part 2 by Passive Income Project
- How the Sharemarket Works by Passive Income Project
If you’ve grasped these lessons, you’re well on your way to understanding how this works.
#2: Do you understand your relationship with debt?
Now, if you find you get the best out of yourself when you’ve made commitments, this might be for you. However, if knowing you have an obligation to someone or something other than yourself causes money worries that get in the way of sleeping well, you’ll need to either work through that relationship by understanding yourself and debt better.
Or explore other strategies.
Check out this blog post to guide your self-reflection: Debt is a double edged sword
Once you are clear on each of these objectives – gaining productive equity, understanding income investing, your relationship with debt – you’re ready to get started.
So let’s have a look at the mechanics.
I’m going to show you how a couple, on a combined income of $180,000 per year, used debt recycling over a 20-year period to:
🏠 Pay off their mortgage 2 years sooner
🏦 Save $48,846 in tax
📈 Improve their net worth by $573,934
💰 Earn an extra $21,863 annually in passive income at the end
How does it work?
Now we know:
- Why debt recycling is a worthwhile strategy to consider
- Identified its suitability for you
It’s time we got our hands dirty and our mind ticking on how it works. I’ll walk you through each step, layer by layer, with our mates Shaz and Dougie. Then I’ll show you a strategy storybook with financial modelling to project its rewards over a 20-year time period.
Here’s some background info on these legends:
Now let’s walk through how they put this strategy into action.
Step #1: Pay down your mortgage
Shaz and Dougie make normal principal and interest repayments on their home loan.
Any money leftover after paying the bills and living the good life (aka extra savings), they channel into making extra repayments on their mortgage.
Their house is worth $1,000,000. Their mortgage balance is now at $600,000. And this is how they view their home:
Now they’re ready to start making some big money moves.
Step #2: Setup an investment loan secured against your home
Shaz and Dougie set up a $100,000 investment loan facility.
This uses all their productive equity.
But to start, they only withdraw and invest half (aka $50,000) into an index fund focused on Australian businesses. Meaning their mortgage is now sitting at $650,000.
Note: They worked with a mortgage broker to secure an interest-only investment loan. This means they don’t pay down the principal (and use that money to pay down the mortgage instead).
Now, each time Shaz and Dougie pay down their mortgage, they match that repayment by taking the same amount from their investment loan and investing it. So, if they repay their home loan from $650,000 to $648,000, they’d withdraw $2,000 from their investment loan.
Meaning they’ve now used $52,000 of their $100,000 investment loan facility.
Yes, their total debt will still be $650,000 – instead of reducing. I’ll get to this shortly.
Step #3: Invest borrowed money into the market
Now that Shaz and Dougie have borrowed money via their investment loan, they transfer it into their portfolio and invest intelligently.
As debt recycling requires a decent amount of passive income, they’ve chosen investments that have a good history of paying high dividends and consistently increasing how much they pay their investors. Putting money into funds focused on investing in Australian businesses tends to be the best way to achieve high levels of passive income.
Our tax system incentivises this, unlike some other governments such as the United States.
Step #4: Use passive income to pay interest on your investment loan
Shaz and Dougie started investing, and now their portfolio is paying them a passive income.
As they borrowed that money from the bank to invest, they’ll pay a good chunk of it back to the bank to cover the interest on their loan. But, if the total dividends are greater than the interest on their investment loan, they’ll also use some to make extra repayments on their mortgage.
And as an added benefit, your portfolio will grow in value over time too.
Step #5: Start looking forward to tax time
If you are debt recycling, you can start enjoying tax time for two reasons. Firstly, you’ll receive a tax deduction for the interest you’ve paid on your investment loan. That’s because investor debt is different from consumer debt.
our home loan is consumer debt, which means it doesn’t help you earn an income.
Your investment loan is investor debt, which means it does help you earn an income.
This is the critical point.
When there is a ‘nexus’ or ‘link’ between your debt and earning an income, say via investing in an ETF or index fund, the interest you pay on this debt can be claimed as a tax deduction.
What does a tax deduction do?
A tax deduction reduces your assessable income, so you pay less tax. If you earn $80,000, then your tax is assessed on $80,000 income, using the marginal tax brackets below.
But if you have a $5,000 tax deduction (like interest from an investment loan), your assessable income is only $75,000 dollars. With that income in the 32.5% bracket, your $5,000 tax deduction means you get to claim back $1,625 when you do your tax return.
The math: $5,000 x 32.5% = $1,625
So let’s compare the home loan and investment loan.
$5,000 in home loan interest means you pay $5,000 to the bank (and that’s it).
$5,000 in investment debt interest means you pay $5,000 to the bank. Then, the tax office gives you $1,625 back in your tax return, meaning you essentially paid $3,375 toward the loan.
As you’ll notice, this number is the same as your tax bracket. Which means if you’re in a higher tax bracket, you can save even more.
Secondly, if you’ve invested in Australian companies, you’ll receive franking credits. These are even more valuable than tax deductions.
Quick caveat: This is only a brief explanation, as it’s not the focus of this guide.
In short, franking credits are more valuable than tax deductions.
Well, the companies you’ve invested in have already paid tax. Their workers are productive → the business makes a profit → they pay a company tax rate of 27.5% on that profit.
So, if the company makes $100 in profit, it pays $27.50 in tax. Then it pays out the remaining $72.50 to shareholders.
Let’s assume you’re the only shareholder. You’d get $72.50 as cash in the form of a dividend – yew! But, they also give you $27.50 as a franking credit – double yew! Essentially, you receive the full $100.
Now, the $27.50 is a “franking credit” and is registered with the ATO, instead of cash in your bank.
At tax time, you pay your marginal tax rate (let’s use the marginal tax bracket of 37% from earlier). 37% tax on $100 = $37. But, you use the $27.50 franking credit to offset how much tax you pay. Your tax is $37, but you reduce it by the $27.50 you received as a franking credit.
You only pay $9.50 in tax.
👉 You receive $72.50 in dividends when the company pays out profits + a franking credit of $27.50 = $100 income
👉 You pay $37 tax on that income
👉 The ATO re-calculates your tax with your credit and gives you $27.50 back when you do your tax return
You end up with $90.50.
Not just the dividend of $72.50 you got first.
That’s an extra 25% of on top of your dividend. This is what makes franking credits so valuable. More money in your pocket. And good times at tax time 🙂
Step #6: Use surplus passive income + juicy tax returns to pay down mortgage
Now Shaz and Dougie are earning extra passive income and have healthier tax returns.
This means they have more to channel into paying down their mortgage. Every time they receive these benefits, they pay off a bit extra. And because they set up a $100,000 facility, they have more that they can withdraw and invest.
Important: There’s a difference in your cashflow timing.
You’ll need to pay interest on your investment loan every month. But your investment will only pay dividends every quarter or every 6 months.
This means you’ll be giving before you’re receiving.
To make this easy, I recommend setting aside 12 months of interest expenses as a cash cushion to cover the first year. That’ll fix the mismatch in timing, plus give you breathing room.
Step #7: Rinse and repeat
Shaz and Dougie keep repeating this strategy until eventually, they have no home loan left. Over the years, it looked something like this:
By using debt recycling, you will completely replace, or “recycle”, your mortgage with your investment loan.
Yewww mortgage free!!
Now, you might be thinking “hang on a minute, I still have the same amount of debt as I had before? What the fucksie?” This is the reality of debt recycling. And when you understand how it works, you’ll welcome this idea of investor debt.
Investor debt is what has allowed you to:
⭐ Invest the whole way through the process
⭐ Channel all your cash flow into repaying your mortgage
⭐ Save a boatload of tax along the way (meaning even more money is invested!)
This can be hard to wrap your head around.
Like any good investing strategy, time does the heavy lifting and the outcomes are exponential. Meaning that the ‘compounding effect’ dramatically increases the space between the potential outcomes as you continue to add the resource of ‘time’.
You’ll see this by noticing the difference between 0 – 10 years compared to 10 – 20 years.
But things can also change pretty quickly.
So it’d be naive to skip over the considerations.
What needs to be true for debt recycling to be effective?
Debt recycling has quite a few moving parts.
With that comes variables that can influence how well debt recycling works for you in the future. For it to be effective, these ideas need to be true:
⚡ You’re disciplined in channeling surplus cashflow into your mortgage and following the steps to increase your investment loan at the same time.
⚡ Your investments pay more in dividends than what you pay in interest on the investment loan.
⚡ You’re committed to this strategy for the longer term to make sure your investments have time to grow and compound.
⚡ You use your increased tax returns to pay off your mortgage, instead of going on a spicy holiday.
⚡ You continue to find the best deals with lenders, keeping your interest rates as low as possible.
You should also consider what could go wrong.
There are a few things that could hinder the effectiveness of debt recycling:
⛔ The interest rate on your investment loan increases
⛔ The income on your investments decrease
⛔ Your personal income and savings capacity is hindered
⛔ Government changes its tax rules and it affects franking credits or your tax deductions (investment loan interest)
⛔ Your home falls in value dramatically and you need to sell your investments to repay debt outstanding against your home
⛔ Your investment doesn’t grow in value and at the ‘end’ your investment loan is higher than the portfolio value
This is not an exhaustive list – only the obvious ones.
Now, it’s time I admit something.
At the time of writing this post, I am not debt recycling.
That’s only because our home is still being built.
But as you can probably tell, I’m a big fan of this strategy. Hence why I decided to write a complete guide on it that includes comprehensive financial modelling. And while I can’t speak to its effectiveness from my own experience, I am fortunate to have been able to study the experience of others.
The benefits of years in financial planning gave me this valuable access.
There is a lot to be gained from adopting a debt recycling strategy.
When you can use investor debt and apply ‘time’, you dramatically collapse the time needed to build wealth. And in truth, debt recycling is probably as advanced as financial strategies go. But that’s not to say you can’t figure out how to leverage it to your advantage.
But let’s recap what needs to happen before you take this on:
1️⃣ Reflect on how you feel when you have debt in your life
2️⃣ Ensure you feel comfortable with investing – and know you’re doing it intelligently
3️⃣ Follow the steps laid out in this post and begin the recycling process
Then, it’s about staying disciplined and letting time do the heavy lifting.
Before you go, this is an ‘evolving post’.
This means I’ll continue to improve and develop this guide based on your feedback and comments below.
Let me know what you’d like to know more about!