What is an Offset Account?
Used wisely an offset account can save you thousands of dollars and help you pay off your mortgage years earlier! We explain here exactly what an offset account is, how they work, and dispel a few common misconceptions along the way.
In simple language what is an Offset Account?
An offset account is just like a normal transaction or everyday banking account, with the only difference being that it is linked to your home loan. Every dollar you have in this particular account “offsets” the balance of your loan, therefore reducing the amount of interest you are charged.
This means that if you have an amount of money in your offset account, each time you make your minimum mortgage repayment you are paying off more of your principal loan amount. Effectively, you will pay less interest to the bank over the life of the loan and be able to pay off your loan earlier!
Many home loans in Australia offer an offset account as a product feature, but they are usually only available with a variable rate home loan.
How do they work?
Let’s look at an example to help us better understand. Say you have a home loan of $500,000 with an interest rate of 6%, and $20,000 in your offset account. This means you will only pay interest on $480,000. Over the life of a 30-year loan, you can save more than $90,000 in interest AND shave three and a half years off your loan!
We have presented some numbers in the table below to demonstrate how much more you could save by increasing the balance of your offset account.
What if you need to use that $20,000 for an emergency? Well, you can! An offset account functions just the same as an everyday banking account. You have the flexibility to access your additional funds whenever needed, although it's important to note that doing so will reduce the amount of interest you save on your mortgage over the life of your loan.
Does an offset account mean lower monthly repayments?
No, even if you offset your loan by 100%, you are still obligated to make your monthly minimum repayment as you technically still owe the lender the remaining principal loan amount. By offsetting, you are only reducing the amount of interest being charged on the loan.
What are their advantages?
1. Flexible and accessible
With an offset account, you can conveniently manage your funds by depositing or withdrawing money as needed. This accessibility sets it apart from other options like a line of credit or redraw facility, which may have more restrictions or limitations on accessing your funds.
2. Higher interest 'return' than your savings
Interest rates on home loans are generally higher than the interest rates offered on most savings accounts. Therefore, even though you don't earn interest on the savings in an offset account, the amount of interest you save on your home loan will typically outweigh the potential earnings from a savings account.
To illustrate this, let's consider an example: Suppose you inherit $20,000 and decide to invest it into a term deposit with a 4% interest rate. After paying taxes at an assumed tax rate of 32.5%, your after-tax (net) return would be reduced to 2.7%. Now, compare this net return to your mortgage interest rate. If your mortgage interest rate is higher than 2.7%, then you’re better off keeping your money in your offset account.
3. Reduce your tax bill
As we now know, funds in an offset account are usually more financially advantageous due to the reduction in home loan interest paid outweighing the interest earned in a savings account. However, an additional advantage that may not be as widely known is that you do not pay income tax on the interest savings obtained through an offset account. On the other hand, any interest earnings from a regular savings account would be subject to taxation at your marginal tax rate. A further benefit to keep any additional funds in your offset account!
4. Take advantage of daily interest
Interest on a home loan is generally calculated daily on the outstanding balance of the loan. So, whether you save regularly or live pay cheque to pay cheque, as long as there are some savings in your offset account for more than one day, you will receive the offset account benefit. To maximise this effect, you should look for opportunities to maintain as much money as you can in this account. For example, you could:
Ask you workplace to direct your salary into to this account.
If you regularly save for an annual holiday, you can still do that within your offset account and withdraw it when you're ready to make a booking. Some lenders will offer multiple offset accounts, making it easier to save for multiple things in their own account (for example a car, holiday or wedding).
Potential drawbacks of an Offset Account
1. 100% vs Partial Offset Accounts
Offset accounts can be one of two types:
100% offset account: 100% of the offset account balance is deducted from your home loan balance when calculating the interest charged.
Partial offset account: Only a portion of your offset account balance is considered when calculating the interest charged on your loan.
A 50% offset account for example: if your remaining loan balance is $500,000 and you have $40,000 in a linked offset account, you would pay interest on $480,000 of the loan balance.
A 100% offset account is the best option and is worth confirming with your lender the type they offer with your loan.
2. Higher fees and interest rates
When considering an offset account, it is important to note that some loan products offering this feature may come with a higher interest rate compared to other loan options. Additionally, there might be higher monthly or annual fees. If these extra costs outweigh the potential savings, it may be more advantageous to consider a cheaper basic loan product without an offset feature. Remember, the benefits of an offset account are only realised if you maintain a balance in the account.
Are Offset Accounts the same as a Redraw Facility?
No. When people refer to a redraw facility, they are typically discussing a feature of a mortgage. It means that your lender allows you to make additional repayments on top of the minimum repayments of your home loan, with the option to "redraw" these extra funds at a later time.
A redraw facility operates in a similar manner to an offset account by reducing the loan balance used to calculate the amount of interest payable. However, there are several important differences to consider, such as:
A redraw facility may have limitations on the withdrawal amount and the number of redraws allowed per year.
You may be charged a fee for each redraw, and there can be a waiting period for the funds to become available.
Compared to an offset account, a redraw facility is generally less flexible and accessible since an offset account is typically set up as an everyday transaction account.
Advanced use of an Offset Account
As we have demonstrated, the greater amount of money you maintain in your offset account and the longer you retain it there, the more savings you can achieve. If you possess strong discipline, you could potentially also employ use of a credit card to defer everyday expenses by taking advantage of the interest-free payment period. Effectively helping you maintain money in your offset account for longer.
However, it is crucial to emphasize that this approach requires careful management, specifically ensuring that you consistently pay off the entire credit card balance before the due date. The interest charged on credit cards is typically much higher than the interest paid on your home loan and can quickly set you back if you become complacent!
It is important to exercise caution when considering this option, as it’s a high-risk strategy with the potential for both significant rewards and drawbacks. This approach is primarily recommended for individuals who possess discipline and financial acumen.
We hope you enjoyed this article on all things offset accounts. If this raised any further questions or you would like to discuss your own situation further, please feel free to call one our helpful team members anytime. We are only too happy to offer advice and help you get the most out of your home loan.