Recycling mortgage debt into 'good debt'

An obvious financial planning strategy that benefits from record low interest rates is to pay off your mortgage more quickly.

With low interest rates should come lower mortgage repayments, leaving more money in the household budget to make additional repayments.

The math of making extra mortgage repayments is, most often, compelling. When mortgage rates are 7.5 per cent, a fairly ‘average' level of mortgage rates by historical Australian standards, every extra dollar that you invest in your mortgage saves you interest at the rate of 7.5 per cent for the remainder of the loan. That is your ‘return' – 7.5 per cent risk free and tax free. A comparatively attractive return.

With mortgage rates now as low as 3.75 per cent, half that rate, perhaps extra mortgage repayments look less attractive. Even though extra mortgage repayments provide a risk free, tax free return of 3.75 per cent, it certainly seems less exciting than earning a 7.5 per cent return in a higher interest rate environment. That said, making extra mortgage repayments continues to be a sound and simple personal finance strategy.

The arguments for extra mortgage repayments

There remains a series of powerful arguments for making extra mortgage repayments regardless of the low interest rate environment. Firstly, for most people a key financial goal is to own their house outright. Extra mortgage repayments are the fastest way to that destination. Secondly, once the mortgage is paid off that is a significant expense that doesn't have to be worried about, and strategies like salary sacrificing to superannuation and investing regularly in an investment portfolio can be adopted. Thirdly, debt is risk. Repaying the mortgage provides a greater ability to cope with circumstances like the loss or reduction of household income.

For those comfortable with the strategy of extra mortgage repayments, record low interest rates help. Lower monthly mortgage repayments should leave more of the household budget for extra repayments.

That said, for people comfortable with holding a level of debt and looking for a more aggressive strategy, the idea of ‘debt recycling' is a strategy worth considering in a time of low interest rates.

‘Debt recycling' as a strategy

Debt recycling works on the fact that there are different classifications of debt. There is ‘terrible debt', which would be the debt that sees 10 per cent-plus interest paid on credit cards and high interest financial products, and which people should always get rid of as a first priority. 

Then there is mortgage debt used to buy a residence, which is often characterised as necessary but undesirable, having a comparatively low interest rate but no tax advantages. Then there is ‘good debt', which is the debt that is used for investment purposes. This is characterised as ‘good debt' because it is tax deductible, and you are using the funds to (hopefully) invest in assets that will grow in value over long periods of time.

Before going any further it is worth stressing that all investment debt increases the risk in a financial situation – we should not be too persuaded by the idea of ‘good debt'. When we borrow money, we are increasing our exposure to both increases in market values, and falls. Those people who borrowed money to invest just before the market fell during the Global Financial Crisis may never find themselves getting ahead on their strategy. As we stand now, it is nearly 10 years later and they are still well behind – an example of the risk of borrowing when asset prices then fall sharply. 

Those words of caution in mind, there may be people looking for a more aggressive personal finance strategy than just making extra mortgage repayments. This brings us to debt recycling.

The basics of debt recycling are that you make extra repayments to your mortgage, while then borrowing to invest in growth assets. Let's say that you have a $200,000 mortgage on your property, and you have decided that you are comfortable with this level of debt in your personal finance situation. You make extra mortgage repayments and you reduce your mortgage to $190,000. At this point in time you set up a second loan, borrow $10,000 and invest in growth assets, for example shares. 

The benefit of the second loan is that it is tax deductible, and you now have an extra asset, being the $10,000 share portfolio. Because you want to keep the proportion of tax deductible debt as high as possible, you would choose to keep the investment loan as an ‘interest only' loan.

You then continue to make repayments to your $190,000 mortgage – perhaps at a slightly quicker pace as you also have some income from the $10,000 share portfolio to help you (admittedly it won't be much at this stage, however it will grow over the course of the strategy). Once the mortgage gets down to $180,000 you might then choose to increase your interest-only investment loan to $20,000 and invest a further $10,000 into your share portfolio.

Over time there should be a number of benefits from this strategy:

1. You will reduce your mortgage debt, and replace it with tax deductible investment debt, while not increasing the total debt beyond a limit that you are comfortable with ($200,000 in the example above).

2. You will build a portfolio of investment assets.

3. You will increase your total income as the investment assets provide an additional source of income, allowing you to increasingly pay your debt off faster (keeping in mind that your level of debt doesn't change from where it started with the strategy, so you are not increasing your debt levels or mortgage repayments).

4. You are effectively investing regularly into investment assets over time. This means that if markets fall, you have the ability to buy more assets at lower prices.

Final word

Debt recycling is not a new strategy. It might be one that is of interest to the more aggressive investor comfortable with a level of debt in their financial situation, looking to build an investment portfolio over time. It is not without risks, and these should be carefully thought through when considering the strategy.