Debt Recycling: Why the Strategy Should Work Before Investment Income Is Counted
By Peter Walters, Principal Planner
For many Australians, paying off the home loan is one of their biggest financial priorities. That makes sense.
While your home may increase in value over time, the interest on your home loan is generally paid from income that has already been taxed. From a wealth-building perspective, it can therefore be a relatively expensive and inefficient form of debt.
Debt recycling is one strategy that may help suitable homeowners reduce their non-deductible home loan debt while gradually building an investment portfolio.
But the way the strategy is structured matters.
We approach debt recycling a little differently here at Pathwise. We believe the borrowing should be structured around the client’s capacity to comfortably manage the repayments from their existing income and cash flow. The strategy should remain sustainable without relying on strong market performance, consistent dividends, or investment income arriving at the right time.
What is debt recycling?
Debt recycling involves progressively replacing non-deductible home loan debt with debt used for investment purposes.
In broad terms, a homeowner may:
Use available equity in their home to establish a separate investment loan.
Invest the borrowed funds into income-producing assets.
Direct investment income and available surplus cash flow towards the home loan.
Progressively reduce the home loan and reborrow for investment purposes.
Continue the process over time, gradually building an investment portfolio while reducing non-deductible debt.
Provided the borrowing is structured and used correctly, the interest attached to the investment portion may be tax deductible. However, the tax outcome will depend on the client’s individual circumstances, the ownership structure, and how the borrowed funds are used.
The potential tax deduction is only one part of the strategy. The broader objective is to use the client’s income, equity, and borrowing capacity more deliberately to build long-term wealth.
Not every debt-recycling strategy is structured the same way
Some debt-recycling strategies rely heavily on income generated by the investment portfolio to help meet the additional loan repayments. Our approach is different.
Before establishing the strategy, we want to see that the client can service both the home loan and the investment loan from their existing household income.
Investment income is not treated as the thing that makes the strategy affordable. Instead, it becomes an additional source of cash flow that can be directed towards reducing the home loan faster. This distinction is important.
Investment income can fluctuate. Markets can fall. Dividends and distributions can change. A strategy that only works when investment returns meet expectations may place the client under financial pressure when conditions become less favourable.
“By ensuring the borrowing is affordable before investment income is counted, the strategy has a stronger foundation.”
Greater freedom in how the portfolio is invested
This approach also provides greater flexibility in how the investment portfolio is designed. When the client does not need dividends or investment distributions to meet the loan repayments, the portfolio does not have to be built primarily around producing an immediate income return.
Instead, the investment strategy can be selected according to the client’s:
long-term financial objectives
investment timeframe
tolerance for market fluctuations
broader financial position
need for income, growth or a combination of both
For a client with a long investment timeframe and the capacity to tolerate market movements, a more growth-oriented portfolio may be appropriate.
For another client, a diversified portfolio combining income and capital growth may be more suitable.
The important point is that the investment decision can be made on its own merits. It is not dictated by the need to generate enough income to keep the debt-recycling arrangement affordable.
Any income generated by the portfolio can then be directed towards the home loan, helping reduce the non-deductible debt faster. However, that income is treated as an accelerator rather than something the client depends upon to meet their regular repayments.
This flexibility does not remove the risks of borrowing to invest. A growth-oriented portfolio will generally experience greater fluctuations, and the loan balance and interest obligations remain even when markets fall.
The investment strategy must therefore reflect the client’s ability to remain invested through both strong and weaker market periods.
Building in room for interest-rate rises
Being able to afford the repayments today is not enough. Interest rates change, household expenses increase and personal circumstances can shift. That is why we also assess whether the client could continue managing the strategy if borrowing costs increased.
As part of our modelling, we generally look for the ability to absorb an additional 2% in interest rates. That buffer may already exist within the household’s surplus cash flow. In other cases, it may require identifying discretionary expenses that could be reduced if rates increased.
Where the surplus is already available, it can often be directed towards the home loan from the beginning. This helps reduce the non-deductible debt faster while demonstrating that there is capacity within the household budget to manage changing conditions.
Why we generally prefer liquid investments
Debt recycling can potentially be used to invest in different asset classes, but we generally prefer liquid, diversified investments that can be purchased progressively and adjusted as circumstances change. Liquidity gives the strategy greater flexibility.
Rather than committing all the borrowed money to one large, indivisible asset, clients can invest incrementally over time. Future investments may also be adjusted as the client’s circumstances, financial goals or market conditions change. Liquidity does not remove investment risk, but it provides more options.
That flexibility is harder to achieve with an illiquid asset such as residential property. Once the property has been purchased, the client is committed to that particular asset, location and borrowing structure. It cannot easily be reduced, changed or sold in small portions.
A liquid portfolio allows the strategy to evolve rather than locking the client into one investment decision from the outset.
How investment income accelerates the strategy
In our approach, household income services the loans. Income generated by the investment portfolio can then be used to make additional repayments against the home loan.
As the home loan is reduced, the borrowing structure may allow the amount repaid to be progressively redirected towards the investment loan and reinvested.
Over time, this can create a cycle:
investment income is directed towards the home loan
the non-deductible home loan reduces
the investment portion of the borrowing gradually increases
additional funds are invested
the growing portfolio may produce further income
that income is again directed towards the home loan
The objective is to accelerate the reduction of non-deductible debt while building an investment asset alongside it. Depending on the investment approach used, there may also be a trade-off between receiving more income now and seeking greater capital growth over time.
A higher-income strategy may help reduce the home loan sooner, but it may also produce taxable income earlier. A more growth-oriented strategy may generate less immediate income but offer different long-term outcomes. These considerations need to be assessed as part of the overall strategy rather than viewed in isolation.
Preparing for difficult years, not only good ones
Debt recycling involves borrowing to invest, so the risks need to be taken seriously.
Investment values can fall while the loan remains unchanged. Interest rates may rise. Household income may reduce because of illness, redundancy, parental leave or a change in working arrangements.
The greatest risk is often not the market downturn itself. It is being forced to sell investments during that downturn because the client can no longer manage the repayments.
That is why a properly considered debt-recycling strategy may include:
an appropriate loan-to-value ratio
principal-and-interest servicing calculations
an interest-rate buffer
surplus household cash flow
accessible emergency funds
an undrawn lending facility
liquid and diversified investments
appropriate personal insurance
regular reviews as circumstances change
These safeguards are not an afterthought. They are central to whether the strategy is appropriate and sustainable.
Who may be suited to debt recycling?
Debt recycling may be worth considering for people who:
have stable and reliable household income
have accumulated equity in their home
maintain consistent surplus cash flow
are comfortable borrowing to invest
have a long-term investment timeframe
can tolerate periods of market volatility
have appropriate emergency reserves and insurance
are prepared to maintain the strategy through different market cycles
It may not be appropriate for someone with uncertain income, limited cash reserves, a short investment timeframe or a low tolerance for investment and borrowing risk. It is also not a set-and-forget arrangement.
The loan structure, investment ownership, movement of money and use of borrowed funds all need to be carefully managed. The strategy should also be reviewed as interest rates, markets and the client’s personal circumstances change.
A strategy that should stand on its own
Debt recycling can be effective, but only when the client’s cash flow, borrowing capacity, investment timeframe and risk tolerance can support it.
The client should be able to comfortably carry the strategy without relying on investment income. Portfolio income can then be used to accelerate home loan repayments, while the investments remain focused on long-term growth.
This creates a more resilient strategy that is better able to withstand interest rate changes, personal disruption, and weaker market conditions.