How the rich use this tax strategy to get richer

He says the strategy is best for mid-lifers or younger pre-retirees rather than anyone closer to retirement because “it’s important to have time on your side in order to allow the investment to earn that capital growth”.

Head of personal finance at Morningstar, Mark La Monica, agrees that debt recycling – sometimes called equity extraction – can be a useful strategy in some circumstances, but can be dangerous to employ without expert advice.

“You are introducing a lot of risk into your personal finances and mainly that risk is around servicing that debt,” he says. “Cash flow is the biggest issue that people need to worry about and there’s a big difference between being a tenured professor and being somebody who works in sales and earns a high commission.”

The risks of debt recycling

While acknowledging that debt recycling carries some risk, Smythe says steps can be taken to reduce it. He suggests investors considering it face the risks upfront by asking themselves the following questions:

• Will you still be able to service the debt if you lose your job?
• What will happen if your investment doesn’t produce the return you’re expecting, and you have to sell at a loss?
• Can you afford to absorb a rise in interest rates?

“If you’re in your 50s, and you lose your $500,000-a-year job it’s pretty hard to get another $500,000-a-year job,” Smythe says, in relation to assessing whether you can service the debt. “Whereas in your mid-40s you probably have a better opportunity to replace that income at a similar level.”

He says capacity to absorb loss is the main reason debt recycling is best employed by people with a high net worth. Although some FIRE aficionados take a highly leveraged approach to accelerate their gains, Smythe recommends clients using debt recycling limit the loan-to-value ratio on their home to a maximum of 50 per cent to limit their risk. Should it all go wrong they may have to downsize, but they won’t lose their capacity to own a home altogether.

The ability of investors using debt recycling to absorb a rise in interest rates was put to the test recently. Smythe says some investors employed debt recycling to buy investment property when interest rates were at their post-COVID-19 lows and were then forced to sell when they found they could no longer service the debt following the sharp rise in interest rates.

In this particular instance, many investors were saved from potential financial disaster because property prices had continued to rise alongside rising interest rates, meaning the majority would have cashed out their investment properties for a profit.

But investors should be aware that this may not always be the case. La Monica says while rising interest rates is one risk involved in debt recycling, the strategy also bets on asset prices rising, be they property prices or share prices. “Taking on debt can enhance returns, as long as things keep going up. But it can be a disaster if they go down,” he says.

Property versus shares

Debt recycling is most commonly used to invest in property but Smythe says it’s important to consider an investment in the context of the investor’s overall portfolio to ensure it is adequately diversified.

“A lot of clients, particularly in Sydney, have a pretty significant exposure to property through their own home. So we would typically suggest they diversify their overall wealth so that they’re not just 100 per cent in Sydney property,” he says.

Smythe says investors contemplating debt recycling should also take into account liquidity when considering where to invest, in case they are forced into a quick sale. “If clients need cash flow for an emergency you can’t sell a bathroom to extract $100,000, but with a share portfolio, you can take $100,000 out or whatever is needed along the way without really jeopardising the strategy.”

That said, while investing in the sharemarket may offer better liquidity, it tends to be accompanied by greater volatility.

Transaction costs are another key consideration, Smythe says, that should be factored in when people are considering the return required to make debt recycling a sound strategy.

Property investment carries high transaction costs associated with buying and selling, such as stamp duty and real estate agent commissions, while there are also costs in maintaining a rental property, managing it and the risk of periods of vacancy. “You need to be alive to the fact that you’re investing in order to chase return and, on that basis, ask whether a particular investment makes sense,” he says.

Smythe says it is best to consider a debt-recycling strategy in terms of the overall return it generates. Given the risk involved, he says the returns produced should be much higher than your cost of living.