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What is debt recycling?
Debt recycling with money in the offset
Should I invest the money in my offset?
Risk tolerance
Determining your risk tolerance
Liquidity and cashflow
Should I debt recycle – final thoughts
What is debt recycling?
Debt recycling is a strategy to convert (or recycle) your non-deductible debt into tax-deductible debt.
Non-deductible debt can be any kind of debt that is not used to purchase investments, but for the purposes of debt recycling, it is typically the loan on the home you live in.
The way debt recycling works is that initially, the interest on your home loan is not tax deductible since your home it is not an investment. However, if you pay part of the loan down, you reduce that non-deductible debt, and if you then borrow that same amount back out and purchase investments (e.g., shares or property) with the borrowed money, the interest on that portion of the loan used to purchase investments is tax-deductible. So you have converted (recycled) that portion of the loan from non-deductible to tax deductible.
Debt recycling with money in the offset
Taking money out of your offset to invest is actually two separate steps:
- Taking money out of the offset to invest is essentially leveraging (much like borrowing to invest) as it increases the amount of money generating interest payable on the loan each month.
- Then, putting it through the loan before investing to convert non-deductible debt into deductible debt is debt recycling.
People often call the whole thing debt recycling when, really, they are separate.
The decision of whether to use money from the offset to invest is a decision about leveraging, not about debt recycling.
Once you have made the decision to invest, debt recycling is simply the conversion of non-deductible to deductible debt by sending that money on a detour through the loan before investing.
So, instead of asking:
should I debt recycle or leave my money in the offset
You should be asking:
should I invest or leave my money in the offset
Now that we know the real question we want answered, let’s learn how to make that decision.
Should I invest the money in my offset?
Money in the offset provides a risk-free return on your money, whereas money that is invested is subject to investment risk.
Using an offset (just like paying down your mortgage) earns you a return equivalent to your mortgage interest rate, and there is no investment risk – your money doesn’t fluctuate with the market, it always has the same value.
The alternative – investing – has a higher expected return than the mortgage rate. Historically, stocks have returned around 10% per annum. But this higher expected return is not guaranteed. The higher expected return comes with higher risk, and that higher risk means a wider range of potential outcomes, so your actual return may differ from the expected return.
So the answer to the question of whether to invest or leave money in the offset lies in determining your risk tolerance.
A high risk tolerance would indicate choosing to invest to get the higher expected return. In contrast, a lower risk tolerance would indicate leaving the money in the offset for the guaranteed return.
A note on returns offered by your home loan offset
The return from using an offset is tax-free due to the return not coming from actual cash received (which would be subject to tax) but rather from reduced interest payment expenses, where no tax is paid on that return. To compare to the return on investing, which uses pre-tax returns, we need to take the interest rate and ‘gross it up‘.
Using 6% home loan interest rate and 32% marginal tax rate (including the 2% Medicare levy):
6% x 1/(1 – 32%) = 8.8%
People mention this all the time, saying that a 10% historical return with your money subject to investment risk is not worth it for just an extra 1% in returns.
However, as we are talking about taking money from an offset to invest in, we would debt recycle that money before investing it, which provides exactly the same tax advantage.
And in addition to that, investing has the following additional benefits to produce an even higher return:
- the risk premium of stocks – typically about 5-6% over the central bank’s official cash rate, or 3-4% over mortgage rates
- returns on delayed taxes on capital gains (and the long-term compounding of these returns)
- the 50% CGT discount
- franking credits
- the ability to sell down investments in retirement on a low or zero tax rate
The take-home point is that just because taking tax into account and showing the grossed-up return of money in your offset is near the historical 10% return on stocks, it doesn’t mean that investing doesn’t have its own tax advantages. So the point remains – the decision on whether to invest or leave your money in the offset is based on your risk tolerance – whether you can tolerate investment risk in exchange for higher expected returns.
Risk tolerance
What is risk tolerance?
In a nutshell, risk tolerance is your ability to leave your money invested for the long term to ride through the ups and downs of the market so that you can get the long-term average return. This is because the market can go up and down in huge amounts over the short term.
On average, every year or so it is normal for the stock market to decline around 5% at some point.
On average, every 2-3 years, it is normal for the stock market to decline around 10% at some point.
On average, every 3-6 years, it is normal for the stock market to decline around 20% at some point.
On average, every 10-20 years, it is normal for the stock market to decline around 30-50% at some point.
However, even when taking these declines into account, the stock market has returned a compound average growth rate of 10% per annum over the last 100+ years. But you need to earn that return, and you do that by remaining invested and not panic-selling when the media is telling you that the next great depression or Armageddon has arrived.
If you sell your investment right after a decline, you end up making a loss, and you would have been better not investing.
So the question is whether you are able to leave your money invested for the long term.
Determining your risk tolerance
There are three aspects in determining your risk tolerance:
- Your ability to take risk
- Your willingness to take risk; and
- Your need to take risk.
Ability to take risk
Your ability to take risk depends on whether there is enough time and earning capacity to still reach your goal by the time the money is needed if things go badly in your investments. This is the ability for your money to be invested long enough to get the long-term average return.
In his book, The Only Guide You’ll Ever Need For The Right Financial Plan, Larry Swedroe came up with these guidelines for the maximum percentage of your money in growth assets based on your investment time horizon.
| Investment horizon (years) |
Maximum equity allocation |
|---|---|
| 0-3 | 0% |
| 4 | 10% |
| 5 | 20% |
| 6 | 30% |
| 7 | 40% |
| 8 | 50% |
| 9 | 60% |
| 10 | 70% |
| 11-14 | 80% |
| 15-19 | 90% |
| 20+ | 100% |
With an investment time horizon of 6 years, a conservative allocation of 30% growth assets and 70% defensive assets is a reasonable choice.
At 10 years, an allocation of about 70% growth assets and 30% defensive assets is a good choice.
And investing for way down the track, a high allocation of 80-100% growth assets is a good option.
An important thing to note about this chart is that the investment time horizon is where your total investment is no longer invested. If you are nearing or in retirement but will be drawing down 3-6% of your investment per year over the next 20-30 years, you still have a long investment time horizon for most of your capital. So most people still have a moderately high ability to take risk at the start of retirement.
On the other hand, for savings goals where you will draw out the entire capital within the next few years, such as saving for a house deposit or saving for your children to be given in the next 10 years, your ability to take risk will be constrained by your time horizon. If you are planning a family and have a date to buy a house within 5 years, investing 100% in equity could result in a 50% loss of your deposit if there is a stock market crash shortly before the time you need your capital. This is why your time horizon constrains your ability to take risk with your investments.
Willingness to take risk
Your willingness to take risk is your ability to stay calm during times of high volatility – when the stock market takes a dive.
Imagine spending decades saving your nest egg of a million dollars and steadily seeing the value of your life savings drop down to $850,000, $750,000, $650,000, $550,000, and now nearing $500,000. You don’t know how much more it will continue dropping or if it will take a decade or more to recover (this has happened before). At some point, most people panic and sell out of the risky assets into risk-free assets, crystallising the losses and ensuring they will not recover. It is human to panic. In the calm of today, you might think you’ll be able to tough it out, but going through it is a whole other thing.
How do you deal with this risk?
The simplest way is to imagine how you would feel if you saw your portfolio drop by specific amounts and determine as best as possible at what point you may panic. Don’t use percentages – you need to use actual dollar amounts based on your current portfolio value when imagining it. Don’t try and be a tough guy. Be honest with yourself. Once you have an estimate, double that maximum tolerable loss and keep no more than that much in equities.
For example, let’s say you have $800,000, and you think you could tolerate seeing it go down to $500,000 but may panic-sell once it gets below that. Your maximum tolerable loss is $300,000. You would then put no more than double that ($600,000) into equities and keep the remaining ($200,000) in safe assets (bonds). Then, in a severe bear market where the stock market drops by 50%, half of your stocks have dropped in value, but your safe assets have not, so your overall $800,000 has only fallen 37.5% to $500,000. The goal is to plan for a maximum drop to where you can continue to tolerate it and leave it invested to recover rather than panic-selling and crystallising your losses, making the loss permanent. Not only will your portfolio value drop less, but you will recover faster since it has less to climb back up.
Do this exercise each year
You should be doing this exercise once a year because your portfolio size and personal circumstances change over time and affect your willingness to take risk. For instance, if you are planning on having a baby and going from DINKS (double income, no kids) to supporting three people on one income, you are likely going to want the option to drawdown on your portfolio in case of a job loss, and you may drop from an ability to remain calm with a 90/10 portfolio down to a 60/40 asset allocation being more suitable until your household has a second income again.
Willingness to take risk is the most critical aspect of risk tolerance
Your willingness to take risk is the most important decision because if you panic-sell when the market has had a significant fall, your ability and need to take risk don’t even come into play, as you have just made sure that the loss from the market fall becomes permanent. Always err on the side of caution when it comes to your willingness to take risk.
Education into the nature of the stock market helps increase your willingness to take risk
As your education into the volatile nature of the stock market grows, your willingness to take risk often increases. Someone who doesn’t understand the stock market is more likely to panic and sell after a 10% or 20% fall because they don’t understand that this is very normal and should be expected based on the understanding that throughout history, the market has always come back and surpassed the previous value if you were patient.
Once you’ve been invested for a while and spent time reading about and seeing the swings of the market, you are likely to feel a little uncomfortable at a 10% or 20% market fall but realise that it has happened before, and it has recovered, and you are more likely to remain invested. For this reason, it is often recommended that someone new to investing start with a more conservative portfolio and reconsider the asset allocation decision after the first and second year, where their education has been the steepest.
Aging tends to decrease your willingness to take risk
While your willingness to take risk increases as you learn more about the nature of the stock market, it often decreases over time, along with your ability to make up losses. For instance, losing half of $100,000 when you are 30 isn’t likely to feel the same as a 50-year-old who has acquired $1 million over 30 years seeing their decades of savings wiped out – not only is their risk tolerance lower with regards to their panic-point, but their risk capacity to re-earn it is also lower.
Need to take risk
Your need to take risk is the return you require your investments to make to meet your goals.
This is calculated mathematically.
Let’s say you’ve determined that a historically safe yearly withdrawal rate of your assets for 30 years was withdrawing 4% of your initial asset value per year, and your income needs (beyond any other income sources such as a pension, annuity, investment property) were $40,000 per year – then you would divide the $40,000 by the 4% leaving you with a need of $1,000,000.
You would build a spreadsheet based on current portfolio value, regular contributions, and the expected return based on the stock-to-bond ratio (more bonds means lower expected return). From that, you could determine how many years you would need to reach your savings goal based on your income needs. If you cannot meet it by retirement age, you have a need to take more risk to reach your goal.
Note that there are other means to lower your need to take stock market risk – by increasing your savings rate, increasing your accumulation time horizon (delaying retirement), or reducing your planned retirement spending. This can be by:
- Investing your time or money in improving your earning prospects
- Picking up a side gig or part-time consulting
- Saving a higher portion of your income
- Saving longer (retiring a little later)
- Avoiding a house upgrade unless it is necessary – or consider an older house and renovating it yourself
- Buying a 3-year-old car instead of a new car
- Downsizing from a 2-car family to a 1-car family.
Risk tolerance summary
Ability to take risk
If I take this amount of risk and things go badly, is there enough time and income to start again and reach my goal before I need the money?
Willingness to take risk
This doesn’t mean ‘do I want to be more aggressive’. It means, ‘how am I going to react when things don’t go well?’
Need to take risk
How much risk do I need to take to reach my goal?
As a rule, you will want to take the most conservative asset allocation of each of the three aspects of risk tolerance.
If your investment exceeds your willingness to take risk and you panic-sell during the downturns, it can destroy years of savings, making need and ability irrelevant.
If you have a low ability to take risk due to a shorter investment time horizon, even if you have a high willingness to take risk, your risk tolerance will be determined by your ability to take due to an inability to make up short-term losses.
If your need to take risk is above your ability or willingness to take risk, you have a conflict and will have to make a difficult decision on how to resolve it.
Liquidity and cashflow
Besides risk tolerance, liquidity and cashflow is the other consideration.
Liquidity
Liquidity refers to the ability to readily access cash. Cash in an offset is an ideal form of liquidity as it offsets your home loan for that amount, so there is no opportunity cost of holding cash in a (taxable) savings account.
Cashflow
Additionally, you could use some of your offset balance for repayments of the amount that would have gone towards the additional interest you pay by having that extra cash in the offset (which does not lower your repayments) compared to paying down the loan and reducing repayments.
In contrast, if you used that money to debt recycle, you now have additional ongoing cashflow requirements on your loan that you need to meet by other means.
For instance, if you recycled $100,000 of debt into investments with a 30-year 6% P&I loan, your monthly repayments would be $7,200 per annum, which is a liability – a non-discretionary expense that must be met, even if you have lost your job or have had other expenses that need to be met.
Using high-yield investments for your debt recycling could help with these payments, but be aware that dividends from shares are not the same as interest from a bond or fixed-term deposit. Unlike bonds and fixed-term deposits, which are legal contracts to pay specific amounts on specific dates, stocks do not guarantee dividends. The company does not owe you dividends. When business turns bad, companies can and do cut dividends, skip dividends, or stop paying them entirely. We saw dividends cut during Covid and the GFC, and these are the times when unemployment increases. In such a scenario, you still have a legal obligation to pay your loan interest or you could default on your loan.
Also, while tax deductions and yield from investments can help provide returns to offset the interest, these do not come at the required time. The tax deduction comes in from your tax return long after your obligation to pay the loan repayments, and distribution from investments is typically only 1 to 4 times per year and is ‘lumpy’ (uneven).
Maintaining a large buffer in an offset account as an extended emergency fund when debt recycling may offer a compromise but be aware that debt recycling and putting money into investment means you no longer have that money as cash, and you must still meet the ongoing loan repayments.
Should I debt recycle – final thoughts
If you have money in the offset and you are wondering whether to invest that money to get a higher return or leave it in the offset, it is important to understand that this is not a question of ‘should I debt recycle’. It is a question of ‘should I invest’.
If you have already made the decision to invest, debt recycling is a no-brainer since you will have the same amount of money generating loan interest either way, but with debt recycling, you get free money by way of a tax deduction.
The question of whether to invest or leave your money in the offset is a question of risk tolerance, which means whether you are able to leave your money invested for long enough to get the long-term average return of the investment.
To determine your risk tolerance, you need to evaluate your ability, willingness, and need to take risk. If you are not comfortable with investment uncertainty and debt, that would indicate you are more likely better off keeping your money in the offset. If you have a long investment time horizon until you need the money and are comfortable with investment risk, then investing has provided a higher return over the long term.