Debt Recycling

Debt recycling enables you to simultaneously pay off non-deductible debts (such as your home loan) and build an investment portfolio for your long term future goals.

Benefits of debt recycling

  • You can use the equity in your home to take advantage of market opportunities now, rather than waiting for your mortgage to be repaid.
  • You will be diversifying your investments outside of the family home.
  • Building an investment portfolio now allows it to benefit from the power of compounding and long term investment growth.
  • Regular investing means you benefit from dollar cost averaging, because sometimes you pay more, sometimes less, for your investment, so your average purchase price essentially evens out over time.
  • Your taxable income may reduce as your deductible loan increases.
  • Your home loan may be repaid faster.
  • You will be able to access your investment portfolio if necessary.

How debt recycling works

 To use debt recycling, you need an existing home loan (or other non-deductible debt) and an investment loan. Your investment loan should be structured as an interest only loan and the funds invested in income-producing assets, such as managed funds or shares.

To implement the strategy, you arrange for all of your investment income to be directed to your home loan in addition to your regular repayments. The extra repayments increase your equity in your home, allowing you to increase your investment loan by the amount you’ve repaid on your home loan. This additional money is then used to increase your investment portfolio.

Over time, as your investment portfolio grows, so does your investment income and the amount you can use to repay your home loan.

Structuring your investment loan as interest only means your repayments are less than if the loan was principal and interest which allows you to direct more of your cash flow to your home loan. The cost of an investment loan is usually tax deductible if the investment is producing taxable income for you, so the interest repayments on this loan can reduce the amount of income tax you pay.

You can revisit this strategy periodically, each time increasing your investment loan by the amount that has been repaid on your home loan with the additional money being used to buy more investments. This process can be continued each year until your home loan is fully repaid. After that time, you can use your surplus income to buy more investments or repay your investment loan.

Other things you should know

  •  Debt recycling is a high risk strategy – if your portfolio performs poorly, or if interest rates increase, you could face significant financial stress or even put your family home at risk.
  • Debt recycling involves gearing (borrowing to invest). You need to understand the risks associated with gearing before undertaking a debt recycling strategy.
  • All borrowing requires discipline. It is important not to over-commit as this will increase the likelihood that ongoing interest and loan repayments can be met.
  • Before making any changes to your loan, you should confirm with your lending specialist what fees and charges may apply if your loan is restructured or if you make additional repayments.
  • You should review your life insurance cover regularly as your debt and asset levels change. It is important to have sufficient cover to help meet loan repayments in the event that your income ceases because of illness, disablement or death.
  • Tax advice should be sought prior to implementing or making changes to investment related borrowings.

Debt Management

Reducing debt is considered a low risk strategy. You can save money in interest payments without the risk of market volatility.

 

Benefits

  • You can reduce the overall interest cost on your loan.
  • You may be able to reduce the term of your loan.
  • You have potential to increase your wealth by directing surplus cash flow towards savings instead of repaying non-deductible debt.

 

Options for managing debt

The following strategies may be able to help you reduce your debts faster, relieve your cash flow, reduce your overall interest cost and reduce the term of your loan.

 

Make additional repayments

A simple strategy to reduce your debt is to make additional repayments with your extra cash flow or savings. Not only will this reduce the level of your debt, but it will also reduce the overall interest you pay over the life of your loan.

 

A similar strategy is to make your repayments more frequently. Interest on your loan balance is calculated daily, so the more frequently you make repayments, the quicker your debt will fall. One idea is to halve the amount of your monthly repayments and repay this amount fortnightly instead. As there are 26 fortnights in a year compared to 12 months, this adds an extra couple of repayments to your loan each year.

 

Use an offset account or redraw facility

Offset accounts and redraw facilities both allow you to put money against your loan to reduce the amount of interest you pay, whilst also enabling you to withdraw the money if you need.

 

  • Offset account – allows you to put money into a bank account which is attached to your loan
  • Redraw facility – allows you to put extra money straight onto your loan.

 

To improve the effectiveness of these features, you could use a credit card with an interest free period to pay for your everyday expenses, thereby allowing your cash to sit longer in your offset account or redraw facility. However this strategy will only be effective if you ensure the full balance of your credit card is repaid in full every month.

 

Consolidate your debts

Debt consolidation is where several loans are combined into one loan account. An example would be to increase your home loan to repay your car loan and credit card debts.

 

Debt consolidation can help to:

  • ease cash flow – annual repayments on the one loan might be less than your total repayments on the separate loans
  • reduce fees – you will only pay account fees and transaction fees on one loan account
  • improve manageability – you will only have one monthly statement and one monthly repayment.

 

Potential disadvantages of debt consolidation include:

 

  • longer repayment period – a loan which might have been paid over a shorter period may be extended unless your total repayment levels are maintained
  • increased interest cost – if your loan term increases, the total interest cost over that term may also increase
  • fees – a loan restructure may incur additional fees and charges.

 

It is important to be disciplined when consolidating debt to ensure that debt is not re-accumulated from other sources. It is particularly important to take care with the use of credit cards – ensure the full balance is repaid every month and/or reduce the credit limit.

 

Repay high interest rate debt first

If you hold a number of different types of loans, such as a home mortgage, a personal loan and a credit card, the interest rate applying to each loan will usually be different, with some rates being considerably higher than others. Repaying the loans with the higher rate first will create savings compared with repaying all the loans at the same time.

 

For example, a credit card will usually charge the highest rate of interest, so by directing extra savings to repay this debt instead of the home mortgage (which usually has a lower rate of interest), you can save interest over the long term. If implementing this strategy, it is important to continue making the minimum required repayments on other loans at the same time.

 

Repay non-deductible debt first

A loan that is used to purchase an asset that does not generate income is called a non-deductible debt. These loans include your home loan, personal loans and credit cards. Your interest repayments on these loans are not generally tax deductible.

 

Loans to purchase assets that produce taxable income for you are called deductible debts. They include margin loans, investment property loans and investment loans to purchase shares and managed funds. Your interest repayments on these loans are generally tax deductible.

 

The tax deduction associated with deductible debt helps to reduce your cost of borrowing. The value of deduction is dependent on your marginal tax rate – the higher your marginal tax rate, the higher the value of your deduction.

 

Example (deductible debt): Tom borrows $100,000 to buy a share portfolio. His interest only loan has an interest rate of 7% per annum and Tom pays tax at the rate of 34.5% (including Medicare). The interest payable each year is $7,000 ($100,000 x 7%). Tom claims this amount as a tax deduction which reduces his income tax otherwise payable by $2,415 ($7,000 x 34.5%). This means Tom has indirectly reduced the interest cost of his loan to $4,585.

 

As non-deductible debts do not contain any tax benefit to help reduce the cost of your loan, these loans should be repaid as quickly as possible.

 

Other things you should know

  • All borrowing requires discipline. It is important not to over-commit as this will increase the likelihood that ongoing interest and loan repayments can be met.
  • Before making any changes to your loan, you should confirm with your lender what fees and charges may apply if your loan is restructured or if you make additional repayments.
  • You should review your life insurance cover regularly as your debt levels change. It is important you have sufficient cover to help meet loan repayments in the event that your income ceases because of illness, disablement or death.
  • Tax advice should be sought prior to making any changes to investment related borrowings.

Interest Rates 101

There is much talk about what the Reserve Bank of Australia (RBA) will do at its next monthly board meeting. Although the Board has a full agenda, the one item most economists and mortgage-holders eagerly anticipate is the cash rate decision. Up, down or no movement?

 

The official cash rate is now 2.0% after the RBA reduced it even further in May in the hope of stimulating growth. Will this push more people into property investment or encourage more to fix the mortgage at a lower rate not knowing what the future will bring?

 

Before you start phoning up real estate agents or making changes to your current mortgage, it’s good to understand what has driven the interest rate consistently down since 2011 so you can make an informed decision.

 

What is affecting our interest rates?

 

Australia emerged from the Global Financial Crisis (GFC) a relatively strong economy, especially compared to the US, UK and much of Europe. To ensure our inflation didn’t get out of control, the RBA steadily increased interest rates until November 2010, holding them at 4.75% until November 2011.

 

However, the global economy continued to grow only moderately throughout 2012 and this, along with declining inflation in Australia, gave the RBA’s Board good reason to recommence reducing rates in early 2013.

 

A couple of months later, with very little change in growth across the major western economies combined with continued lower key commodity prices in Australia, the Board reduced the cash rate to a new low of 2.75% hoping it would stimulate sustainable growth.

 

By August 2013, little had changed forcing the RBA Board to apply yet another reduction, this time to a remarkably low 2.5%.
Although that move stirred the sleeping giant and attention to property started to return; it wasn’t fast enough. With inflation falling below 3%, the RBA further decreased rates to just 2.25% in February 2015, and, to the surprise of many, again three months later to a paltry 2.0%.

 

Is it time?

 

With the cash rate at such a low level, it might be a good time to shop around for a better deal. Exit fees were abolished in July 2011, so the power is in your hands. The only constants in life are taxes and change, so a long-term mortgage will never remain static.

 

The information provided in this document, including any tax information, is general information only and does not constitute personal advice. It has been prepared without taking into account any of your individual objectives, financial situation or needs. Before acting on this information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. You should read the relevant Product Disclosure Statements and seek personal advice from a qualified financial adviser. From time to time we may send you informative updates and details of the range of services we can provide. If you no longer want to receive this information please contact our office to opt out.

Judging investment performance


We all have different attitudes to investing. Some people are conservative and don’t like any variability in returns. Others accept the roller coaster of the share market as a short-term price to pay for better long-term performance. Some people will have both of these attitudes – conservative with their short-term savings and aggressive with their long-term investments.

 

It is probably unfortunate that the short-term performance of long-term investments is reported so often. The media often makes announcements such as “super funds balances boomed last month” or “share investors go backwards in one day”. Returns over short periods are probably irrelevant to a long-term investor.

 

But this reporting does shape the way people think about their investments particularly where shares are involved. You can expect shares to fluctuate in value over the short term but perform well over complete economic cycles.

 

There is a theory that when investors hear about these short-term returns they react in three different ways. Obviously, reactions depend on the most recent investment performance, but these are the most commonly made judgements (they might be familiar to you):

 

“I could have done better in the bank”

 

There will be times when growth assets under-perform term deposits. A lot of investors have thought this in recent years. As we are now witnessing with low interest rates, this is not true at the moment.

 

“I missed out”

 

There will be times when shares and property surge and someone you know will tell you they achieved 50% or 100% returns. The Australian residential property market was like this in 2002 and 2003 and the share market was similar between March and September 2009. Don’t worry, that time will come again so get in and stay in.

 

“I’m going backwards”
There will be times when shares produce negative returns. However history has proven time and again that sound share investment sees you “going forwards” over the long term.

 

Trying to achieve above-average returns at all times throughout the investment cycle is a recipe for disaster. It is tempting for investors to try to “time the market” – moving between asset classes by trying to predict the “next winner”. A better approach is to choose your own benchmark that will enable you to meet your goals. Then focus on a long-term strategy to achieve this return. A prominent investment axiom states “time in the market is more important than timing the market”.

 

Your financial adviser can help design a portfolio to meet your specific needs for the short and long term, so you don’t have to carry any regrets.

 

The information provided in this document, including any tax information, is general information only and does not constitute personal advice. It has been prepared without taking into account any of your individual objectives, financial situation or needs. Before acting on this information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. You should read the relevant Product Disclosure Statements and seek personal advice from a qualified financial adviser. From time to time we may send you informative updates and details of the range of services we can provide. If you no longer want to receive this information please contact our office to opt out.