What you need to know:
- An interest-only loan lets you minimise loan repayments while maximising your tax deductible costs.
- You can use money saved in an offset account to buy an investment property while maximising tax deductions.
- Paying off your mortgage directly (instead of putting money in an offset) actually decreases the tax benefits.
Why offset accounts on interest-only loans work well for investors
Combining an interest-only loan with an offset account lets you offset your taxable income and minimise your costs. It's a good strategy for anyone who wants to turn their home into an investment later.
An interest-only home loan with an offset account offers a doubly effective tax strategy for property investors. It works like this: An interest-only loan minimises your loan repayments in the short term because you only pay off interest. And as an investor, these interest payments are tax deductible.
But your actual debt doesn't go anywhere. If you put money into an offset account attached to the loan, you can effectively build up your savings as if you were repaying the loan. But you can use this money as you need, which offers greater flexibility. And because you're not actually paying the loan principal off, your loan repayments are tax deductible.
A home loan offset account works like a bank account. You can save money in it, and spend if you need to. Every dollar in your offset reduces the interest payable on your mortgage by the amount held in the account.
For instance, if you had a mortgage of $450,000 and you had $25,000 in your offset account, you would only owe the bank $425,000. When the lender calculates your daily interest, you'd only be charged on the $425,000 owing, instead of the $450,000.
What are the benefits of using an offset account on an interest-only loan?
Opening an offset account on an interest-only loan has several benefits for investors, including:
- Lower repayments. As mentioned above, as you will only be paying the interest portion of the loan, your periodic repayments will be lower, freeing up your cash for other investments.
- Tax deduction. You can claim a tax deduction for interest paid on your property if it is clear that the purpose of the loan is for investment. To claim the interest as a tax deduction, you should focus on reducing the interest payable on the non-deductible debt.
- Separation of debt. With an interest-only home loan, you can keep the original debt separate. You can then put savings into an offset account against any debt that's not tax deductible. This means you can move your savings to whichever debt is not tax deductible, which helps separate your debt.
- Contingency buffer. An interest-only mortgage with an offset facility effectively provides you with a contingency buffer to cover unexpected costs or a lifestyle change.
Turning your home into an investment via an offset account
Let's say you want to upgrade your home, so you buy a new place. But then you decide you want to keep the old place as an investment property.
This is easy to do. But if you've repaid most of the loan on your original house, you've actually reduced your tax benefits as an investor.
Why? Because as a home owner, lower debt is good. But as an investor, interest charged on debt is tax-deductible. You want a smaller debt on the house you live in and a bigger one on the investment.
Here's an example:
Andrew's home loan and tax situation
Andrew lives in an apartment. He has a $450,000 mortgage, and he's made repayments over the last few years. He now has $250,000 left on the loan.
Andrew decided to buy a new place but keep his old unit as an investment. To cover part of the new home purchase he pulls some money out of the original loan. His original loan turns into an investment loan.
Interest charges on Andrew's investment loan (the old property) are now tax deductible. But because he repaid so much of the loan (rather than putting it in an offset) the tax deductible amount is only the remaining $250,000.
As a result, Andrew has minimised his tax deductible debt and increased his non-deductible debt which is not a good tax outcome.
What Andrew should have done
If Andrew had taken out an interest-only mortgage with an offset account, he could have resolved this problem.
Instead of paying down the principal portion of the loan, Andrew could have put his additional savings (that would otherwise be principal repayments) into the offset account. This would have helped Andrew minimise the interest payable on the outstanding loan amount.
When he converted his property into an investment, Andrew could have withdrawn funds from his offset account and use the funds as a deposit for his next property purchase. Then his investment loan debt would be bigger, and thus his tax-deductible debt would be bigger.
How can I set up this loan structure?
Before you take out an interest-only loan with an offset account, you need to work with a savvy mortgage broker, financial planner or tax specialist to evaluate your financial position. Identify the amount that you can afford to put into the offset account each month and discuss your investment strategy with them to see whether this structure will allow you to meet your investment goals.
If you make additional repayments during the interest-only period, and you can cover the extra repayments when the loan reverts back to principal and interest, then an interest-only loan with an offset could be a good structure to consider.
Compare interest-only investor loans
Many of the loans in this table come with offset accounts.
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