How do Mortgage Offset facilities work? Do they live up to their promises and are they right for you?
Offset Overview
In simple terms this transaction account (called a “100% Offset Account”) is linked to a mortgage or some cases, a commercial loan.
Interest is calculated on the balance of the Loan, less the balance in the offset account. Interest is not credited on these savings, instead it works directly against the loan it is connected to.
For mortgage holders, It is often provided as part of a “packaged loan” that includes the loan account(s), offset savings account and usually a credit card too. The package option can be attractive to help leverage bigger interest rate discounts too.
Using a credit card for expenses may help maintain more funds in the offset account for longer. Assuming the credit card is cleared in full each cycle, the interest free period can effectively reduce interest on the mortgage.
You can generally pay directly into the loan without penalty, and redraw on the loan with minimal restrictions.
These products are generally branded “Standard Variable Loans” or “SVR’s” and will be discounted according to the borrowing amount.
Potential Value - Offset Accounts
• There may be tax considerations, especially if the loan is used to acquire a rental property or you intend to eventually rent the property.
• The convenience of the automated nature of this facility - having all your banking with one lender and not needing to manually manage your banking.
• You borrowing amount is relatively small, or your income is very considerable, maximising the proportionate interest rate savings.
Redraw Overview
Essentially, this is a loan account linked to your transaction bank account for loan repayments and redraw. Redraw usually has no or minimal restrictions and should be fee free. However, redrawing on funds may extend the length of your loan.
Every day interest is calculated on the balance of the Home Loan and charged monthly.
Where possible, aim to direct a salary to the loan, and redraw only what you need to help minimise the interest on the loan. You can employ a credit card to pay for expenses - to keep extra funds in the loan to help reduce interest, as long as you pay down the credit card in full each monthly cycle.
You can pay direct into the loan without penalty and redraw on the loan. Although tax advice is recommended in view of the changes to ATO TR200002 regarding tax deductible expenses, especially for business loans with a redraw facility.
These products are generally branded “Basic Variable Loans” or “BVR’s” and often priced the same or a little under packaged offset loans.
Potential Value - Redraw Facility
• You do not intend to rent out the property and happy to repay principal.
• You want flexibility to make extra repayments to reduce your mortgage, but seek access to those surplus repayments via redraw.
• Your income or offset balance is more modest, or mortgage is larger. This may negate benefit if the offset structures has a higher interest rate.
• You enjoy being more active in managing transfers between your mortgage and your transaction account.
What is Opportunity Cost?
Opportunity cost is an economic concept defined in simple terms as the next-highest-valued alternative use of a resource. For example, if you spend $100 going out to dinner, you cannot spend that $100 on your next best option.
Applying this to financial matters, if the alternative to investing new cash flow income of $300 per month (let's say at a 4% annual return) is to spend it going out to dinner each month, your financial opportunity cost over 5 years would be $19,890.
What many households, and some businesses, do when they have additional cash flow (such as a gift, pay rise, home loan rate fall), is to consume it in full on expenses, rather than use it to offset debt (mortgage, credit card, other loans).
Of course, if you invest the funds instead don't forget to factor in taxation.
Using these broad assumptions, the most benefit is generally obtained when the loan amount is smaller, as the interest rate charged on the loan itself is more material where the amount of the loan is higher.
What is right for you?
This is a basic example with assumptions that will apply differently in most circumstances.
It does however confirm a few principles that all borrowers can consider:
- When managing a mortgage - understand your Opportunity Cost (i.e. could you get a better return on the money in your offset or redraw if the funds were directed to other purposes).
- Consider the average balance of an offset account during the loan term, a consistent balance will have more impact (this may be highly connected to your level of income).
- Consider the loan amount in proportion to your income - a redraw facility can have more impact on a smaller loan with a larger income.
- Aim for an offset account that does not have a significant interest rate or fee premium to obtain the most benefit.
For further insights into Mortgage features, terms and rates that meet your goals and objectives, please use our Mortgage Finance Guide.