Debt recycling as a strategy for low-interest rates

With interest rates at historic lows, financial strategies around managing mortgages are important. While it is a great time for people to get ahead with their mortgages with low-interest rates allowing extra repayments, at the same time, and somewhat perversely, the 'earnings' from the strategy of making extra repayments to the mortgage have never been lower — the 'earnings' from extra mortgage repayments are equal to the interest saved, which gives an annual return of only around 3 per cent at the moment, equal to the interest rate of the loan.

This earning rate is tax-free and better than a taxable 1 per cent to 2 per cent from a cash style investment, but it is still not an exciting return.

We are talking here about playing around with one of the ‘sacred cows’ of conventional personal finance wisdom in Australia – pay down your mortgage as quickly as you can. And, most of the time, the logic is absolutely sound.

If you are getting rid of debt and ‘earning’ a return of 7 per cent a year tax-free through saved future interest (when the mortgage rate is 7 per cent), then it makes sense. However, with interest rates on mortgages around 3 per cent, the strategy of simple extra mortgage repayments becomes less compelling.

Homeowners who are comfortable with keeping a level of debt in their overall financial situation might consider another strategy called 'debt recycling', where extra repayments are made to pay down the mortgage, with a second investment loan then used to buy other assets. This strategy keeps the level of debt constant, builds a base of growth assets and, over time, the loan changes from being a non-tax-deductible mortgage to a tax-effective investment loan.

Let's consider the strategy in more detail.

Let’s assume a person with a $600,000 house has an outstanding mortgage of $300,000. They are comfortable with some level of risk in their personal finances, so don’t see any great need to reduce their debt overall. They have the capacity to pay an extra $10,000 off their mortgage every six months through extra repayments.

Over six months they make the extra $10,000 in repayments and reduce their mortgage to $290,000. They then set up a small investment loan secured by their $600,000 property, and borrow $10,000 to invest in growth assets, in this case, let’s assume shares.

Their position after six months is that:

They have total debt of $300,000, although $10,000 is now tax-deductible, being the loan used to buy the $10,000 in shares.

They have a share portfolio worth $10,000, producing income of about $200 every six months (assuming a 4 per cent yield) – they can now use this income to make extra repayments to the mortgage, paying down non-tax-deductible debt even more quickly while increasing the investment loan and growth assets.

Let’s now assume we are twelve months along in the strategy, and they have another $10,000 extra to put towards the mortgage, as well as the $200 in income from the growth portfolio. They increase the investment loan by $10,200 to buy additional shares.

Their position after twelve months is that:

They have a total debt of $300,000, although $20,200 is now tax-deductible.

They have a share portfolio worth $20,200 (plus or minus any fluctuations in value), producing income of around $404 every six months.

The race between the mortgage vs the potential growth assets

The financial benefit in this strategy is the increasing base of growth assets and the income stream that this provides. The total loan stays at $300,000 in nominal terms, however, it is worth remembering that inflation will be slowly decreasing the real value of the home loan.

The value of the strategy can be conceptualised as a fairly simple race – a race between the possible ‘earnings’ (interest savings) from extra mortgage repayments (somewhere around 3 per cent at the moment), and the earnings from the growth assets. In weighing the options, it is important to keep in mind that this earning rate is volatile, whereas the 3 per cent earned from making extra repayments is risk-free.

However, if you are comfortable with the two layers of risk in the strategy, holding a level of debt and owning volatile growth assets, then debt recycling might be a strategy to use to take advantage of the low-interest-rate environment while building a base of investment assets.

The hypothetical growth asset that we used in this situation were shares, largely because with residential property it is hard to invest fractional amounts like $10,000, and it is worth keeping in mind that the dividends from Australian shares would include the benefit of franking credits.

This, in turn, provides two sources of tax advantage from this case study, an increasing tax-deductible investment loan and an increasing stream of franking credits.

Conclusion

It is hard not to wish for simpler financial times – when a modest interest rate in the economy meant that homeowners made extra mortgage repayments and retirees were paid reasonably for having cash assets in the bank.

Historical low-interest rates challenge those simple strategies. For those people paying off mortgages, and who are comfortable with a level of risk in their personal finances, thinking about ‘debt recycling’ as a way of building some growth assets while making their mortgage increasingly tax-deductible is a strategy that might suit these unique and ultra-low interest rate times.