Pay off your home loan in 6 years | Offset Accounts deconstructed

| May 22, 2014

I just opened a  Property  Investor magazine  today  and saw this property investment spruiker advertising “ Pay off your loan in less than 6 years” and i said myself , “Geez thats what i  need” .

No really – i dint tell myself that , because  there is  so much more to that statement  than people understand . To simplify it down to you, i can say  it has to do a lot with offset accounts –  (Having one or not having one).

mortgage with offset account

For the examples and calculations below i will take  my current bank  commonwealth bank rate of  6.40% p.a. and savings amount of $50,000 for the offset account to explain how it works.

What is an offset account ?

A mortgage  loan is made  up of two repayments, the principle and the interest repayments. The principle repayments if the actual price you paid for the property and  processing fees etc  and the interest repayments  is the fees  the bank charges you to give you the loan.

Offset loan by itself is a simple thing , put some money into an offset account  linked to your mortgage loan and reduce and save on the interest repayments  part on your loan. But  there can be many factors  that actually influence if you really  gain any benefit from an offset account  and this can be interrelated to many other factors .

Offset accounts do not generally reduce your repayments. Your repayments are the same. The best benefit is derived from an offset account when you have spare cash and the loan is a interest only loan.

Simple example of how offset accounts  work

Lets say you have borrowed  350k at 6.40% variable rate with an offset account attached to it. Lets just say you have 50 k spare money  in savings, which then  you put into your offset account.

As this 50 K is sitting in your offset account , the bank will charge you interest only on ($350,000 – 50k ) = $250,000 rather than charging you interest on the whole amount of $350,0000 as they would normally do.

So 50k of your loan incurs $0 interest and you are paying 6.40% interest only on the remaining 250 k. In this scenario your repayments would be as quoted by the lender however you are paying more off the principle of the money while you have 50 k in your offset account.

You can always withdraw your 50 k amount from the offset  account but the moment you withdraw the money, you will los these benefits  as mentioned above  that you receive with an offset account.

Why offset accounts  are not really  needed to pay off your loan quickly ?

While explaining to you the benefits  of a offset account  above,  i will be the devils advocate and  let you know why you actually don’t need it , as apposed to most property investment spruikers who recommend it .

First  of all how many people actually have a spare $50 to 100 k  lying around to throw into an offset account. Not many . If you  really just have 10,000 to 20,000 will it really make a dent by putting it into a offset account ,yes maybe  but then is it worth it for that benefit received.

You can easily not have  a offset account  and just throw that  spare $10,000 or $20,000  into your mortgage loan directly. If you make extra repayments on your loans, you can get rid of your debt faster. You will save money in interest payments and take a financial load off your shoulders (If you choose a loan at a fixed rate, you may not be able to make extra repayments without incurring extra fees.-Check with provider)

The amount of  interest you can claim as deduction ( for investment properties and negative gearing)  reduces , making you pay more tax in your regular income received.

By making extra repayments your loan gets paid down quicker  and so you can  easily  do a redraw anytime if  you need money( though  this will negate the whole process of putting in the money  in  the first place, its available for an emergency). Another benefit of putting any extra money that you may have directly into your home loan will reduce the balance of your mortgage thus reducing your minimum monthly mortgage repayment when interest rates drop.

Make your monthly repayments into fortnightly or weekly repayments and shave of years off your mortgage loan

Interrelated factors that affect offset accounts

Does you offset account  actually give benefit of interest repayments  when you actually need those amounts incurred  for negative gearing.

Would you rather gain interest ( and income) on savings account rather than reduce interest repayments with offset account ?

Would you rather pay off  you mortgage loan with the 50 k  amount , so as to reduce the term of the loan and have it available for redraw rather than it sitting in a offset account ?

Would borrowing money  to put in a offset account  actually benefit you  as you will be paying interest rate on that borrowed money ( trust me i know  a person who did this and was bleeding more money than she was gaining)

Why keep money in an offset account when  you can put that money towards you over due on maxed out credit card/s and save more money or pay out that margin loan that has a much higher interest rate

Commonwealth Bank vs. Westpac : Offsets accounts

For offset accounts is best to first find out if the offset account is a 100 % offset account as you can get less savings if its not a 100 % offset account > most of the top banks offer 100 % offset account, but its wise to check as this can make a difference in the long term. Many smaller banks or credit unions don’t offer a 100 % offset loan though offer cheaper loan rates, so they offset their income from customers in one way or the other

Finding the right offset account with the right provider also needs some research and right now Westpac Bank is more consumer friendly by offering a daily savings account that can also be used as a offset account, while Commonwealth Bank only offers a offset account that has to be only used as an offset account. Which means if its hard for you to save a lot of money you would prefer the Westpac offset account option.

The option of  giving you a savings account as a offset account can also work against you  if you are not  a dedicated saver, thus not leaving you with much cash in your account to actually benefit from the offset account, while is could be easier for some people to just have a dedicated separate offset account  to help them save

Taxation off offsets accounts

Interest from a savings account is considered income, so you will be taxed on it as if it were income. An offset account  balance is deducted from the mortgage loan , so it’s not income, so you’re not taxed

If you do take money from redraw (unless for investment purposes),  the ATO see’s it almost like a new loan for personal reasons. Where as with offset you can freely access the money in there as you like(because its your money), with no tax implications.

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Detailed calculation of a Offset account to mortgage loan

Rough explanation of a 100% offset (Most banks Provide 100%, though its wise to check). Thanks to Konazz from whirlpool forums

You have a mortgage of $200k (30 years @ approx. 7% interest rate = $1330.60/month).

You also have $50k in savings (earning 6% interest).
I’ll do this on month n=1
So a repayment of $1330.60: Principal = $163.94 Interest = $1166.67 (excel ammortisation calc)
Interest on savings = 6%/12months x $50000 = $250

1) With 100% offset, and $50k sitting in offset account :
Your mortgage payment is $1330.60 (as the repayment is based on your contracted agreement, irrespective of what is in the offset account)
Interest payable = $875 (based on both interest Dr and Cr being @ 7%; excel ammortisation calc @ $150k)
Principal repayment = $455.60 ($1330.60 less interest above)
Interest earned = $0
Loan amount outstanding: $199,544.40
Cash at bank = $50,000
Net Position = $149,544.40 (money you owe the bank)

2) With no offset, $50k sitting in interest savings account @ 6%.
Your mortgage payment is $1330.60 (as the repayment is based on your contracted agreement, irrespective of what is in the offset account)
Interest payable = $1116.67 (normal repayment calc)
Principal repayment = $163.94
Interest earned = $50000 * 6%/12 months x .685 (31.5% marginal tax rate) = $171.25
Loan amount outstanding: $199,836.06
Cash at bank = $50,171.25
Net position = $149,664.81 (money you owe the bank)

So in  1month you have $122 less to pay the bank on your mortgage loan just by having an offset account.  Now  compound  that over a regular 30 year mortgage and it makes a big difference.

The above calculations  are taken based on the marginal  tax rate as 31.5 %,  but the amounts calculated could differ based on your tax rates  and Medicare levy etc.

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Features to Check for in a offset account

Make sure its a 100 % offset bank account for the loan.

If you can get a offset account that offsets both variable and fixed parts of the loan, its even better.

The offset account which is not an every day transaction account but only a savings account is even better.

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Category: 2013, Australia, Example, Featured, finance, home loans, Investor, loan rate, Mortgage rates, negative gearing, rental properties, Tax Deductions, Tips Home loans

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Comments (2)

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  1. anne says:

    350,000 – 35k = 300,000, not 250,000 as you have calculated and stated in paragraph 2 under the heading “Simple example of how offset accounts work”

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