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).
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.
