For each day that you owe money to the bank on a home loan, interest accrues on that loan. You make periodic home loan repayments and if your home loan is a P&I loan (see Home loan products: P&I vs IO loans), the value of your loan, the principal, will slowly trickle downwards. What if you want to pay more? What if you want to reduce your interest liability but you want flexibility in accessing the cash in the future? Let’s use a 500k loan with an interest rate of 3% as our example. In this example, you happen to have a spare 100k in cash sitting in a savings account and you want to apply this money towards your home loan. You have 3 options.
Pay off some principal
If you’re absolutely certain you want to permanently reduce the value of your loan and you understand the advantages and disadvantages of doing so, you can talk to your bank about depositing a lump sum and reduce your principal (within your loan’s terms and conditions that you definitely didn’t read when you first signed up). If your loan terms allow, you may be able to make ongoing repayments higher than the minimum required by your bank or you may be able to deposit the lump sum. We’ll use the lump sum in our example because it’s easier.
Your 500k loan with a 3% interest rate (assuming no other fees) is accruing 15k per year in interest. It’s a little more complicated than that because you’re supposed to calculate daily interest and let it compound but for simplicity’s sake, we’re going with 15k. If your bank allows you to park your spare 100k in your mortgage, your loan is reduced to 400k and will accrue 12k per year in interest instead. Unless your mortgage has a redraw facility or an offset account, this 100k is now no longer accessible. Refinancing of course always remains an option if you want to go down that path.
A redraw facility allows you to access extra principal repayments (including potentially any lump sum payment you make towards your loan over and above your repayment obligations). Not all loans have redraw facilities so be sure you check with the bank and properly understand the terms of redraw before making any rash decisions. Applying your 100k towards your 500k loan works in much the same way as the example above. And for every day those funds are applied to your loan you’re saving interest. The difference is that instead of that 100k being inaccessible (bar perhaps in the event of refinancing), you can withdraw, or redraw, the 100k. There may however be some very important tax considerations with doing so – best to speak to an accountant before jumping the gun.
These bad boys were super popular back in the day – and by back in the day I mean pre-covid. An offset account works like any ordinary transaction account. Imagine instead of stashing your 100k in a separate bank account, you set up a transaction account tied to your home loan which allows you to reduce your interest liability for every day the 100k sits in the account, but is totally accessible at all times when you need to make use of it. You can genuinely use it as a transaction account for your ongoing expenses. Interest is (usually) calculated daily so your interest rate is applied to the value of your loan less whatever figure is in your offset account at the end of the day.
When covid struck and interest rates started to plummet, most people thought that interest rates on variable home loans would decrease as the central bank brought in extraordinary policies to drive down borrowing costs. This logic made sense – they are called variable home loans after all. Instead the big Australian banks collectively decided to characterise themselves as a giant bag of phalluses and reduce fixed home loan rates (new customers only of course). The running theory is that they suspected many Aussies on variable home loans would be too lazy to search around for more bang for their buck – hoping that at least a large proportion of them would continue to pay higher interest rates on variable home loans despite there being some significant discounts to be had on the market.
Why is this relevant to offset accounts? Well we learned in Home loan products: Variable vs fixed rates that offset accounts are much more likely to come with variable rate products and we’ve just learned that variable rate products are now more expensive than fixed rate loans. Let’s do the math using our 500k loan and 100k lump sum example. Here we consider two products on offer. The first is a variable interest-only loan with an offset account at average rates I’m seeing in the market. The second is a 2-yr fixed rate interest-only loan without an offset account at average rates I’m seeing in the market. Both products are for residential investment.
|Product||Rate||Loan amount||Interest p.a.||Cash in offset required to breakeven (vs no offset)|
|Variable IO loan (w/offset)||4.00%||$500,000||$20,000||$187,500|
|Fixed 2-yr IO loan (no offset)||2.50%||$500,000||$12,500||–|
The example above is fascinating (it is to me at least). If you had zero cash in your offset account in the first example, you’d be paying 20k in interest every year, compared to 12.5k in interest every year in the second example. The first example has an advantage – the offset account – but your 100k just isn’t enough to bring down the interest liability to match that of the fixed rate loan. If you’re curious, 100k in your offset account would have you pay 16k in interest every year – still quite a lot more than 12.5k. The point is that with such striking differences in interest rates between variable and fixed rate loans currently in the market, you need a whopping lump sum of money to make them worthwhile, even with a relatively small loan of 500k – the example gets much worse if you have a bigger loan.
There’s also something to be said about opportunity cost (which we cover in Economics 101). The cost saving of your 187.5k lump sum is 4% interest saved on 187.5k, or 7.5k per year. Think about the opportunity cost of stashing your 187.5k here. Could you have earned more money in the share market? Could you have used this lump sum as a deposit for a second investment property? Could you have spent a fraction of the money on a discretionary purchase that may have brought you happiness over and above the value you attribute to the cash and the interest savings – such as movie tickets, books, new kicks (preferably not birkenstocks)? If this example has scared you away from offset accounts but you’re still curious, we did cover “hybrid home loans” in Home loan products: Variable vs fixed rates. Hybrid home loans can be used as an ingenious little trick to get around the expensiveness of offset accounts and still take full advantage of them.
Finally, offset accounts have a different tax treatment to redraw facilities because you’re not technically paying down any principal and it’s that reduction of principal aspect of a redraw facility which has the potential to give it a different tax treatment in the event you wish to redraw funds. Best to speak to a tax expert before digging yourself into an irreversible hole.