Recycle your debt
July 8, 2009
PORTFOLIO POINT: Balancing tax-deductible and non-deductible loans, or 'recycling debt', is an easier way to pay off a mortgage and build an investment portfolio.
When the federal budget halved tax-deductible contributions to super some investors were left wondering whether they were running out of strategies to boost their returns. But there are other ways.
There's no denying super's attraction: compulsory employer contributions, salary sacrifices and the contributions of the self-employed are all taxed at 15% compared with as much as three times that for income received in your own name. Further, investment earnings in superannuation are taxed at a maximum of 15% and withdrawals by over-60s are tax-deductible. The list goes on.
So what are the other options for people who had been contributing more than $25,000 of tax-deductible contributions each year?
An alternate strategy, "debt recycling", involves taking on some investment debt while at the same time repaying your mortgage, a non-tax-deductible debt.
To see how it all fits together, let's consider a 40 year old couple with a $200,000 mortgage on their house. They have $20,000 a year of surplus cash flow, which they had previously been putting into superannuation.
Let's also assume that they are comfortable with a level of debt of $200,000 in their overall situation. Their house is worth $500,000.
A good use of surplus cash flow is simply to use it to pay off the mortgage - paying the $20,000 a year towards their mortgage will reduce the principal, mean they pay less interest over time and improve their financial situation by eliminating debt.
A debt recycling strategy goes one step further.
During the first year the couple directs their surplus income to their mortgage, reducing it to a value of $180,000 (keep in mind that the $20,000 is above their normal repayments, so reduces the principal by the value of the extra repayments).
The couple then organise a second loan, secured against the property, to use to invest in growth assets such as shares. After this first year they redraw $20,000 from the second loan and invest in shares.
So now they have:
- $180,000 of debt in a non-tax-deductible mortgage.
- $20,000 in a share portfolio.
- $20,000 of debt from an investment loan.
Whether they simply pay the $20,000 on to the loan, or pay the $20,000 on to the mortgage and set up a $20,000 investment loan, their financial position is the same. The benefit of the debt recycling strategy is that they now have $20,000 of tax-deductible debt, and a $20,000 share portfolio.
In the second year the $20,000 surplus income is again used to pay off the mortgage. The income from the share portfolio is also used to pay off the mortgage - at a yield of about 4.5% that would be a further $900 repayments.
At the end of the year $20,900 is redrawn from the investment loan, to keep the total loan balance at $200,000.
So they now have:
$159,100 in a non-tax-deductible mortgage.
$40,000 share portfolio plus capital growth.
$40,900 investment loan.
Given that the income benefit of the shares (dividends and franking credits) equals the cost of the loan at the moment, the success or failure of the strategy rests with assumptions about the growth in value of the portfolio over time.
If the value of the portfolio and dividends grow - which over 10-year periods has been the case in Australia - then the strategy will be rewarding.
There are, however, clear risks with the strategy. Borrowing to invest is intentionally risky: you are increasing the volatility of your situation in the expectation of providing a long-term benefit to your position.
For example, if you had started this strategy two years ago, you would be significantly underwater and probably preferred to have just paid off your mortgage instead. But recognise that the long-term average return of the sharemarket over the past 30 years is 12.6%, which can produce sizeable benefits.
The benefits of the strategy are three-fold:
You are reducing your non-tax-deductible debt.
You are building a passive income stream from the shares.
The increasing stream of dividends from the share investments helps pay the mortgage off faster.
There are a lot of problems with the most frequently used approach to borrowing to invest, whereby a lump sum is borrowed and invested using a margin loan.
Three of these problems include:
Margin loans are often very expensive.
There is the risk of a margin call when the value of a portfolio falls sharply, forcing you to sell at a time when markets have fallen.
Investing a big lump sum at one time means that you are very exposed if the market drops suddenly.
A debt recycling strategy provides a solution to all of these problems. Borrowing against your house is usually cheaper that a margin loan, without the concern of a margin call.
Because you are investing on a regular basis (each year, for example), if markets do fall you have the advantage of making further contributions over time and buying more assets at lower prices.
A debt recycling strategy is certainly more suited to those people comfortable with investment risk. At the end of the day it won't work unless there is a reasonable return on the investment involved.
For those willing to take that risk, it provides a way to build an investment portfolio over time, reduce your non-tax-deductible debt and start to build a passive income stream from your investments.