Build wealth via debt recycling
Steve and Karen have a home worth $450,000 and an outstanding home loan of $220,000. They are keen to pay this off as quickly as possible and would like to start creating long term wealth. Having spoken to their financial adviser, they have decided to employ a debt recycling strategy.
They use existing equity in the family home to borrow for investment purposes. They’re comfortable having a total debt level equivalent to 67% of the current ($450,000) value of their home (ie $300,000). Given their outstanding home loan is currently $220,000, they will initially borrow $80,000 via an interest only investment loan, and invest it in an Australian share fund.
Throughout the first year, they use all of their surplus cashflow, around $10,000 (less the interest on the investment loan), and the investment income and tax savings, to pay down the home loan by $24,047 to $195,953. They then replace the amount paid down by borrowing an equivalent amount as an investment loan ($24,047) to purchase additional units in their share fund.
Note: Total borrowing is still capped at $300,000.
If they continue this process, their home loan will be paid off after 8.8 years. After recycling at the end of that year, the investment loan would be fully drawn to $300,000 and the value of the share fund would be $410,352. With the home loan paid off, they can direct all surplus cashflow, investment income and tax savings into the share fund.
To illustrate the benefits of this strategy, compare it (over 20 years) to using surplus cashflow to pay off the home loan as quickly as possible, and after it is repaid, directing the rest into a share fund.
Assumptions: Investment return is 8.5% pa (split 3% income and 5.5% growth). The franking level on income is 75%. The interest rate applying to the home loan and investment loan is 7.5%pa. These rates are assumed to remain constant over the investment period. The investment and loans are in Steve’s name. Steve and Karen use salary crediting and credit cards. At the end of 20 years, all investments are sold, capital gains tax paid and loans repaid.
In the second scenario, although the home loan would have been paid off in around eight years, the value of Steve and Karen’s portfolio in year 20 would be only $730,345. By using debt recycling, however, Steven and Karen have an investment portfolio worth an extra $218,313 after all taxes and repaying all loans (despite taking slightly longer to repay their home loan).
Caution: Before you use a gearing strategy, you should ensure you have a suitable timeframe (preferably five years or longer) and understand the risks. For example, if your investments fall in value, your financial situation could be significantly worse than if you don’t use a gearing strategy.
Tips and Traps
It is important your investment loan allows you to make interest-only repayments, so you can direct more cashflow into paying down your home loan. It can also be beneficial to have a higher pre-approved limit for you investment loan. This avoids additional paperwork and fees when adjusting your loan balances each year
A line of credit (which has investment and home loan sub-accounts) can be an efficient means of implementing debt recycling. Be aware that lines of credit generally have higher interest rates than standard home loans.
With a debt recycling strategy, some of your surplus cashflow must be used to meet interest costs on your investment loan. It may therefore take you slightly longer to pay off your home loan than if you used just a surplus cashflow strategy. However, with a debt recycling strategy you can acquire an investment portfolio sooner.
Having paid off your home loan you generally have the choice of using surplus cashflow to purchase more investment assets, or reduce the debt on your investment loan. Assuming the after tax return from your investment is greater than the interest cost (which is deductible), you are generally better off investing, provided you are comfortable with the total level of debt.
As an alternative to debt recycling, you may want to establish an interest only home loan, invest your surplus cashflow in superannuation and use your super to repay your home loan in retirement (see your financial adviser for more information).