Trying to select the right mortgage can be confusing and frustrating. By the end of this article you will have a good understanding of what is a mortgage offset account, it’s advantages and disadvantages.
There are thousands of products available, all with different features, fee structures and interest rates.
What is a Mortgage Offset?
An offset is an account linked to a mortgage that instead of paying interest, reduces the amount of interest you pay on borrowed money.
If you have a $500,000 mortgage and $25,000 in the offset account, you will only pay interest on $475,000.
At today’s incredibly low rates, that equates to $675 per year saved in interest (assuming just 2.5% interest rate).
1. You will Save Interest
Inflation is the increase in costs of goods and services over time, and the Australian government aims to keep inflation at 2-3% per year. If your savings do not earn at least enough to compensate for inflation, they are losing real value over time.
It is essential that any money kept for a long period of time (several years) is invested so that it is not losing purchasing power. This is why investing, not just saving, is the secret to long-term wealth accumulation. However, most of us need a cash emergency fund available in case of unforseen disaster.
John is an excellent saver and has accumulate a $20,000 emergency fund (enough to cover 3 months living expenses).
In ten years time, assuming John doesn’t fall victim to lifestyle inflation, his emergency fund will only have $15,526 of purchasing power (Just over 9 weeks of living expenses). If he doesn’t ever use his emergency fund, he will need to keep topping it up each year to keep pace with inflation.
Mortgage interest rates are generally higher than inflation (although at the moment, not by much). By saving cash in an offset account, it is saving enough interest to compensate for inflation.
Good savers, accumulating tens of thousands of dollars in their offset and planning to keep it there for a year or more will benefit. A mortgage offset is an ideal place to save for your next car, childrens’ education and store your emergency fund. Offsets “pay” more the higher the interest rate.
Credit card users
Those who use, and pay off credit cards every month can keep monthly income in their offset account for the 55 day interest free period of certain credit cards.
2. You will Pay less Tax
Any measly amount of interest paid on a savings account is taxed at your marginal rate. For those with a non-earning partner, an account in their name alone would pay no tax. Anyone who has earned more than the tax free threshold ($18,200) will pay tax on interest at their marginal rate (up to 45%).
Offset accounts save interest payable, but don’t pay interest. There is no taxation on interest earned, making offsets a tax efficient strategy.
Self Employed Earners
If you pay tax quarterly or annually rather than by PAYG, the tax you owe can be reducing your mortgage interest bill until the payment due date.
3. You Will Pay More Fees
A mortgage with an offset account will generally cost more than a basic “no frills” account. A mortgage offset is more advantageous the higher interest rates are, and the more you will have saved sitting in the offset account.
Many home loan packages charge around $400 per year in comparison with bare bones loans that may have no annual or monthly fees. A mortgage offset may also charge a higher interest rate than the bare bones loan.
There are other factors that affect the interest rate you are offered. These include how much you are borrowing, your loan to value ratio (how big a deposit you have), credit score and whether the loan is for a home or investment.
To work out whether an offset account will save more than it will cost, you will need to estimate have much you will have saved long term in the account. It needs to be in the tens of thousands generally. Compare this with the additional cost of the interest premium, and extra fees.
Additional Fee from Offset + Additional Annual Interest NEEDS TO COST LESS THAN Savings X interest rate for you to benefit from an offset
An additional $400 annually in fees would require more than $13,400 in savings at 3% interest to make the additional fees of having a mortgage offset acccount worthwhile.
4. You will Maintain Flexibility
Situations change faster than you expect. Next year you might get the opportunity of a lifetime, and need to move interstate. Keeping savings in your mortgage offset account instead of paying the mortgage down directly, means that you can withdraw the extra repayments and maintain tax deductibility.
Imagine you have a mortgage of $500,000 and store savings in a mortgage offset account totalling $100,000. You can withdraw the $100,000 after deciding to rent out your home. The entire interest bill on your $500,000 can now be deducted against income, reducing your tax bill, or allowing negative gearing. The $100,000 withdrawn can be used as the deposit for your next home.
If had the same $500,000 mortgage and paid $100,000 into the mortgage directly (with or without redraw feature), only the interest on the remaining $400,000 can ever be deducted again. This is a really common error.
You may not think you are going to move, but if you have an offset account anyway, it makes sense to keep your options open incase circumstances change.
If you have extra savings and put them into your investment property offset rather than direct them to the mortgage directly you can withdraw your savings when you suddenly need a new car. The mortgage unpaid remains tax deductible.
5. You can Use Mortgage Offset Cash to Replace the “Cash” Allocation in your Portfolio
It has never made sense to me having a percentage of cash included in investment asset allocation. Asset allocation is often presented as a pie chart as below
The idea of asset allocation is to
- Diversify your investments – no-one can consistently pick the best performing asset class for the next decade. Owning a bit of everything means you will own some of the best.
- Smooth performance. By investing in one asset class that falls, whilst the other rises, your overall year to year performance is likely to be less volatile.
The traditional cash allocation is low risk, low volatility and low return. But we all need some cash, as an emergency fund. It makes a lot of sense to me to have my only cash allocation as my emergency fund and general cashflow in a mortgage offset account. This way, at least my lowest risk investment is still keeping pace with inflation.
What Types of Offsets are there?
There are partially and fully offset accounts. Partially offset accounts will offset a pre-agreed amount of your savings (say 50%) against the mortgage.
The better and more common option is a 100% offset account. If you have $10,357 in your offset account you will not pay interest on $10,357 of your loan. Ideally you want a loan where the interest savings are calculated daily, so temporary increases (pay day) in your balance make an impact on interest paid.
What Kind of Mortgages Are Offsets available for?
Variable vs Fixed Rates
Traditionally, offsets have been available for variable rate loans, either principal and interest or interest only.
“Variable” loans change the interest rate you pay on a loan with minimal notice. The Reserve bank of Australia meets 11 times a year to decide whether interest rates should change. The banks may change rates in line with the RBA decision, choose not to pass on a rate cut, or apparently increase rates without RBA advise.
Fixed loans have a fixed interest rate for a predetermined length of time (often 1-3 years). This provides peace of mind, and are particularly useful for home owners who would struggle with an increase in interest.
Recently I have noticed fixed rate loans offered with 100% offset accounts attached. This sounds enticing for those requiring security of a fixed rate, but check out fees and interest rates charged carefully.
Despite them sounding a bit of a rort, most borrowers have been financially better off with a variable rate. The banks price in likely interest rate movements in the fixed rates offered. The banks have far better information than you or I to base their predictions on. Whether the variable rate advantage will continue during these times of ultra low interest rates remains to be seen.
Principal and Interest vs Interest Only
“Principal & Interest” loans require you to start paying the loan capital back from day 1. Interest charged gradually reduces as the loan is paid back.
“Interest only” loans do not require you to repay the loan, only to pay interest charged each year. These are usually in place for 1-5 years, when they will revert to a principal and interest loan. The principal then needs to be repaid over the remaining 25-29 years unless refinanced.
Interest only loans can be useful for property investors looking to maximise tax efficiency. They may also be useful for home owners who have fully offset their home loan. The offset cash can be withdrawn if the home is later used a rental, and tax deductibility of interest maintained.
When the loan term comes to an end, borrowers have got into trouble because they are unable to refinance. Lending conditions have significantly tightened, some homes have fallen in values and personal circumstances changes. If the borrower has no ability to refinance, repayments skyrocket, and they can be forced to sell.
What is the Difference between an Offset and Redraw Facility
These two look very similar initially. An offset and redraw are both ways you can use savings to reduce the interest paid on your mortgage.
They both theoretically allow you to withdraw those savings (and consequently increase the interest paid again).
However, the bank have control over money in a redraw account, and not in an offset. Should a major economic calamity occur, the bank can stop cash redraws if you (or they) are in a financially precarious situation.
In contrast, your offset money is yours, and you have the right to withdraw it at any time without permission.
Redraws can also sometimes be limited, either by needing to give notice, or by the amount or frequency of withdrawals. Offsets generally have no such restrictions.
What is a Comparison Rate
A comparison rate is always quoted alongside the interest rate offered on mortgage products. The comparison rate includes fees alongside interest payments for a $150,000 over a 25 year loan.
The idea is that you can directly compare the total of one mortgage product against another. Unfortunately, most will be borrowing far in excess of $150,000, making the interest rate a bigger factor for larger mortgages. It is worth looking into fees in detail to calculate which product will be most cost effective for you.
Who is a Mortgage Offset Not Useful for
Broke first home buyers who don’t expect to be able to save much will not benefit from an offset account. If you are in this situation, make sure you can definitely afford the loan!
What is a Mortgage Offset: How to Find a Loan
You should have a clear idea of whether a mortgage offset is suitable for your situation. Start by checking out options on a comparison site such as Canstar. Find yourself a mortgage broker to help you negotiate the best deal. Take the time to do the maths for your personal situation and find the best loan for you.