With interest rates decreasing for many people, it has made it more attractive to invest again, rather than paying down the mortgage,

With this, there has been an expression of interest in debt recycling. If someone is going to invest rather than pay down the mortgage, they want to legitimately minimize their taxes.

Debt recycling is not at all popular (or familiar) in New Zealand. So today, I thought I would share a one stop shop for everything you need to know about debt recycling in New Zealand.

In this comprehensive article, we will explain what debt recycling is, how debt recycling works (with examples), the impact of debt recycling, the benefits of debt recycling, structuring your debt recycling, the risks of debt recycling, and then we will provide a calculator for you to complete your own debt recycling analysis.

 

What is debt recycling?

Debt recycling is where you borrow money from your mortgage loan and use those borrowings to invest.

You cannot claim tax on the interest payments of a mortgage in NZ, so it is considered bad debt from a tax perspective. You can however claim tax on your investments if you have borrowed that money, which is considered good debt. Note though the investments must produce an income.

If you just invested the money, you wouldn’t be able to claim tax back because it went straight into investing. But if you borrow the money and invest in assets that produce an income, you can claim money back.

The key thing to note is you are not taking on more debt. You are not borrowing more money from the bank to invest. That is leverage and can be dangerous.

You are using money you would have invested anyway.

You are using the money you have used to pay down the mortgage and drawing that back out to invest. Essentially turning your bad debt into good debt.

You will end up with a higher return on your investment than you would otherwise because you are taxed less, as you now have a tax deduction that you wouldn’t have had before.

 

How does debt recycling work?

With money you are going to invest, you pay down your home loan instead. You then immediately pull that money back out and invest it.

End result is you are still investing the same money. It just has the extra step of putting it on the mortgage very briefly, before taking it back out to invest.

Through this extra step, you are making that money tax deductible.

Over time, as you invest more, more and more of your mortgage debt becomes investment debt and hence, tax deductible. If you do it long enough, and are investing enough, your entire loan will be tax deductible.

Let’s say you have a house valued at $800,000 and you have a home loan of $500,000. You also have $50,000 of savings you are about to invest.

You can then contact the bank and split your home loan in two. One for $450,000 and one for $50,000.

You then pay off the $50,000 loan with your savings and immediately pull it back out and invest.  

As long as you invest in an income producing asset, that $50,000 is now tax deductible.  

Assuming a 6% mortgage interest rate, 2% dividends (income), and a 28% PIR tax rate, the two options are as follows:

Debt recycling – $1,000 dividends received ($50,000 x 2%). You can claim $3,000 of interest ($50,000 x 6%) as a tax deduction. Dividend tax of $280 ($1,000 x 28%). Deductible tax of $840.  Tax savings of $560 for the year ($840 - $280).

No debt recycling – No tax savings as investing with unborrowed money is not tax deductible.

In both situations, you’ve paid the same amount of interest, your mortgage is the same size, and you have invested the same amount. The only difference being you have saved some money in tax. Your level of bad debt has decreased, while your level of good debt has increased.

You may be thinking $560 in this example is not much of a saving for all that effort. You may be right. However, this perspective is rather short-term. The real benefit coming years down the track as the bad debt (non recycled) decreases and the good debt (recycled) increases. Plus dividends and tax savings can be used to speed the process up even further by creating more recyclable cashflow. We will take a look at the longer term impact of debt recycling now.

 

The impact of debt recycling

We will use the same numbers from the above example and extrapolate them over 15 years.

We will assume an initial 30 year mortgage term and 3% investment returns (after investment fees and any investment taxes). Remember we have separated out dividend returns earlier of 2%. So total investment returns in this example is 5%. We will also assume that dividends and tax savings from debt recycling are used to pay down the mortgage. Finally, we will assume you are willing to invest $20,000 a year, increasing with inflation.

Here is how that situation would look at different time points:

Almost $68,000 better off by debt recycling. $173,000 over a 30 year period.

What if the mortgage interest rates were just 4% rather than 6%?

Almost $43,000 better off.

Or what if the mortgage interest rates were 8%?

$98,000 better off over 15 years.

The big caveat here though is can you receive better returns investing than paying down the mortgage at these higher rates?

These results only show the difference between debt recycling and not debt recycling for money already intended for investment. You still need to carefully decide whether you want to pay down the mortgage first. The decision to engage in debt recycling should be made after deciding to invest. Tax decisions should not be the priority.

If investment returns are higher or lower, then that will change the results too. Higher investment returns enhance the benefits of debt recycling through increased dividends. This equates to not just a higher portfolio balance, but also more tax savings.

If you are on a lower tax rate, the results are still good, however not as favourable as if you were on a higher tax rate.

Changing the mortgage loan length also affects the results. A shorter home loan will have a smaller impact on the results. This is due to a higher allocation of funds towards the mortgage, resulting in less available for investing.

You can play around with the different investment, mortgage, tax, and timeframe variables with the calculator I will link to at the end of the article.

 

The benefits of debt recycling

• Higher returns, no change to risk: It’s as good as a free lunch as you will get. You are able to increase your returns without taking on any additional risk. All by reducing your tax paid. This strategy could save you many thousands of dollars. This of course assumes you were going to invest anyway. Investing solely for tax savings is not a good strategy.

• Home loan can be paid more quickly: You can also pay off your home loan more quickly if you want. By using investment dividends and tax savings to pay down the mortgage, you can pay the home loan off faster.

• Encourages diversification: If you are on the fence about investing or paying down the mortgage, it can tip the scales towards investing. This is not a bad thing in New Zealand generally speaking, because a lot of people don’t invest enough. Paying down the mortgage has been the default option for many people, but it is not always the best decision. Having your net worth spread over multiple assets helps to diversify your risk.  

• More cashflow: More tax savings means more money for any other financial  opportunities or demands you may have.

 

Structuring your debt recycling

There is no one special loan for debt recycling. It can be any type of loan provided by your bank.

The key characteristics required of the loan are that you are able to split the loan with the bank and able to redraw the money you pay down the mortgage with.

The reason you want to split the loan up is so that there is a clear distinction of what money you used for debt recycling. If you mix your debt recycled loan with your normal non debt recycled mortgage, it can be an administrative hassle, not to mention the risk of falling offside with the IRD. Mixing loans (good and bad debt) also means you won’t receive the full tax benefit. It will be apportioned.

With the split loan, you then want the ability to be able to draw the money out. Just be careful when drawing the money out you don’t close the loan. For instance, if you have a $50,000 loan and withdraw $50,000 to invest, some banks might close the account, preventing future debt recycling. Check with your bank first. If that is the case, maybe reserve a dollar.

Debt recycling can be done with various home loan products, although certain products may offer advantages over others. If you are uncertain about how to structure your debt recycling, consulting a mortgage broker could provide assistance.

The most prevalent approach to debt recycling involves saving a lump sum of money, using it to reduce the mortgage balance, reborrowing the amount that was used to pay down the mortgage, and then investing those funds.

Dividends and tax savings, which have already been invested and received preferential tax treatment, can then be used to pay down the mortgage which will create more equity, more cashflow, and more opportunities for debt recycling in the future.

You can also debt recycle with smaller monthly savings instead of a lump sum, though it may take longer before you can invest. Most banks have a minimum size of which they will open a loan account for you. In this instance, you will need to calculate if the savings from debt recycling make up for the time you are not investing.

You would ideally want an interest only loan for the loan that you draw your money from. By not having to pay down as much of the mortgage, you get to free up more cashflow allowing you to reach the next tranche of debt recycling even sooner.  However, you absolutely want to be paying principal on the rest of the mortgage that hasn’t been used for debt recycling.

 

The risks and gotchas of debt recycling

• Timeframe: The shorter the timeframe, the more risk debt recycling entails. This is because many investments can do poorly over the short term. You could be worse off by debt recycling than not debt recycling. Potentially you could even owe more than your portfolio is worth. It should be a long term strategy.

• Not considering goals: If for example, you are thinking of retiring without a mortgage and that extra cashflow, by debt recycling you can extend the length of your mortgage, which can impact on your goals.

• Surplus income: You need more income than your current mortgage payments and cost of living. In other words, you need savings. If you are likely to go through long periods of not being able to save much money, the benefits of debt recycling may not be worth the time and costs. Job security is also an important consideration here. Loss of income would not be good for the debt recycling strategy.

• Relationship differences: Although debt recycling is not borrowing more money, it is extending how long you will have the mortgage for, than if you rather paid down the mortgage. You don’t want to go ahead with this strategy if one person in the partnership is against debt or wants the home loan gone. Even if there are financial benefits, the risk of ruining the relationship is not worth any monetary gain.

• Moving homes: If your current house is not your long term home, then debt recycling now may not be ideal. If you sell before buying a new home, you will have to wind up the debt. Potentially not having enough time to make this strategy worthwhile. It would also mean less equity in the house available to use to upsize house for example.

• Mixing loans and cash: With debt recycling, you want clean and separate accounts. With mortgages you want the loan you are recycling separate from the loan you are not recycling. Then when investing the money, you want to make sure there are as few stops as possible between when you pay down the mortgage and when you invest. For example, you don’t want to draw down the mortgage to your cheque account, which then means mixing debt money with your other money, and then sending it to a investment brokerage account that has some cash sitting in it, again mixing different money. You’d ideally have the money go into accounts with zero cash. Otherwise you may not be able to claim the full tax deductibility and you could find it more difficult to track your recycling if you ever need to answer to the taxman.

• Interest only loans: Can be stopped by the bank or potentially can cost more than non interest only loans. The benefit of debt recycling may still outweigh this risk, but still worth considering.

• Higher mortgage rates: On the surface higher mortgage rates would mean more tax savings from debt recycling. But the question should not be debt recycle or not debt recycle. It should be pay off the mortgage or invest. And with ever changing mortgage rates, the decision should never be set and forget. There will be times where paying down the mortgage is best, and times where investing is best.

• Bank scrutiny: Some people don’t like drawing a bank’s attention to their situation. By conducting a debt recycling strategy, you may face a little more scrutiny from the bank. Likewise, if you convert your loan to interest only, you will likely face more scrutiny again.

• Loan structure: You need to find a loan that allows you to split your mortgages up and then redraw. Otherwise you may face additional fees. Ideally you will also find a loan that allows you to draw down to zero dollars and still keep it open.

• Time consuming: It can be time consuming, especially at the research and set up stages, to use a debt recycling strategy.

• Misusing debt: You need to make sure you are using the debt to buy income producing assets. If you use the debt to buy an asset like Bitcoin or a tech share company that doesn’t produce dividends, then your debt is not seen in the eyes of the IRD as deductible debt.

• Rental property: If you think you may ever rent out your current residence in the future, debt recycling may not be for you. This is because, depending how long you have been debt recycling and how much, a lot of the mortgage interest is now in your investments (not the mortgage). That will mean much less interest (if any) to deduct against the rental income which is a huge tax disadvantage.

• Money management: You need to be a good money manager for debt recycling to work. A lot of people pay down the mortgage because they can’t trust themselves to invest the same amount if there were no mortgage payments. Not only that, but debt recycling requires regular review and management. You need to keep accurate records.

• Selling shares: When I see debt recycling being discussed, I see people recommending selling their shares to pay down the mortgage and then reinvest that same money to buying the same shares. Debt recycling is legal. It is using saved money to invest. The main purpose of this money is to invest. Secondary reason is tax benefits. It is not using invested money to pay down the mortgage and invest again. The way I see it discussed is plain and simple tax avoidance and is illegal. Wanting to invest is not a reason here because you were already invested. The primary reason to invest in this example is minimizing tax and that is tax avoidance.

• Not having an exit strategy: What will you do once the bad debt has been fully recycled and turned into good debt? Or what about if you have an unexpected setback? All too common people jump into debt recycling without having thought about this.
  

To minimize these risks, I recommend implementing this strategy only if you are likely to be a good saver over time, are not thinking of selling your property, are on the same page with your partner, and are in it for the long haul. Also important to consider how debt recycling impacts the wider picture and your goals. Finally, investing wisely is a no brainer. This money should not be used to invest aggressively. Low cost, diversified index funds is best.

Hiring the relevant Financial Advisers, Accountants, and Mortgage Advisers is also a good idea so you can be assured you are making the most optimal decisions and doing everything by the book.

This is quite the list of risks, but I frequently see debt recycling come up in conversations as a no brainer. No one online ever details out the risks because they are not professionals. They don’t do this for a job. It’s my job to make sure you go in with your eyes wide open and look at both sides of the coin.

 

Final thoughts

Debt recycling can be a great strategy, but it is not for everyone.

It is best for those with:

• A long term view

• Higher tax rates

• Good income relative to spending

• Partners on the same page

• A home they are unlikely to use as a rental property

• Time and capacity to deal with the extra paperwork and administration

• Trusted professionals around them who can help implement the plan

• An exit strategy once the bad debt has been fully converted to good debt

It can still work if some of the ingredients above are missing, but you will need to be more careful before jumping in.

Whatever you do though, don’t let the tax tail wag the dog. This means don’t make a decision to debt recycle or pay down the mortgage based on tax savings. Make the decision to pay off the mortgage or invest first based on other matters like cashflow, potential returns, diversification, timeframe, and so on. Then if you decide to invest, then you can consider tax savings. Just make sure you are only recycling money you were going to invest anyway.

Most people like to keep their personal finances simple, and if that is you that’s fine. This strategy can be slightly complicated and time consuming and is not for everyone. If you don’t mind a bit of extra work and time, debt recycling may be for you.

 

As promised, you can find the link to the debt recycling calculator on this page. There are two versions available for free download. One where you can see the tax impact of debt recycling. Another calculator where you can compare debt recycling to not debt recycling to paying down the mortgage.

If you need help with any financial decisions , then get in touch today.

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here