Understanding the power of offset accounts

Wednesday, 8th Aug 2012
Categories: Finance, Newsletter

offset account

Most people would have heard of offset accounts, but only a few fully understand how valuable they can be. An offset account looks like a regular everyday bank account and even operates like one, but there is one significant difference. It is linked to a home or investment loan and any money in the account will automatically reduce the amount of interest payable on the loan and therefore help the borrower to potentially pay off the loan and build equity quicker.

It may help to look at a simplified example. Let’s say you have a loan of $350,000 and $50,000 sitting in an offset account. The interest on your loan would be calculated on $300,000 not $350,000, just as if you had deposited the money directly in the loan. If you are paying principal and interest on the loan, your repayments would stay the same, but a greater proportion of your repayments would go towards paying down the loan principal. If you are paying only interest on the loan, your interest payments would be calculated on $300,000, the difference between your loan balance and the balance of your offset account.

Here’s another way to think about it. Whatever interest rate you are paying on your loan, you are essentially earning that same rate of interest on the money in your offset account. If you had put that money in a regular savings account rather than an offset account, not only would your interest rate be lower but any interest earned on your savings would most likely be taxed. Savings made from an offset account are not considered interest and therefore aren’t taxed.

It’s clear that an offset can help you to pay off your loan much faster, especially when you deposit any available cash into the account and leave it there as long as possible (remember interest is generally calculated daily, so every dollar and every day counts).

Some people will have all their income (wages, rental income) paid into the offset account and use a credit card to cover all their living expenses. They will then pay off the credit card at the end of the interest free period, to ensure their cash is working for them as much as possible. Strategies like this can end up knocking ten years off the term of a loan and save the borrower tens of thousands of dollars, if not hundreds of thousands.

On the surface, it might seem that a free redraw facility on a loan is just as good as an offset account, but there are key differences. If the loan is for investment purposes and the interest is tax deductible, withdrawing money from the loan using a redraw facility can cause tax problems, especially when the money is used for personal use. If you make extra repayments into the loan and then redraw the funds at a later date, that portion of the loan may no longer be tax deductible and the problem can get worse with every redraw.

With an offset account, which is separate from the loan, you can use funds freely for personal or investment use without worrying about the tax deductibility of the interest payments. Another disadvantage of a redraw facility is that it can take 2-3 days for the money to be made available, whereas an offset account is just like a regular bank account with instant access via an ATM card, cheque book or online banking.

It’s true that lenders generally charge a monthly or annual fee for the privilege of an offset account, but, if the account is used properly, any fees are likely to be insignificant compared to the massive benefits that can be gained.