The easy way to reduce the amount of interest you pay on your home loan each month is to use an offset account
An offset account is a transaction account which reduces the interest payable on your home loan by the amount held in your account.
For example, a 100% offset account with $50,000 in it, on a home loan of $300,000, would see interest-only calculated on a balance of $250,000. On a home loan of 5.50% over 30 years, this could amount to a saving of $90,000 in interest, with seven years cut from your home loan.
To calculate how much one would save you, use our offset home loan calculator.
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What is an offset account?
An offset account is like a regular transaction account that has been linked to your mortgage account. You can deposit funds at any time and withdraw them again when you need to via ATMs and EFTPOS transactions. You can even pay bills from your offset account online via BPAY, or set up an automatic direct debit agreement with your creditors to have payments deducted from your account.
The primary difference is that every dollar you keep in the account actively reduces, or 'offsets' the amount of interest you pay on your mortgage.
For example, if you have a 100% offset account and have $10,000 in savings sitting in it and your mortgage balance is at $300,000, your interest charges are calculated on the balance of $290,000.
Another way to illustrate how an offset account might work is to imagine that you have a mortgage of $300,000 and you also have $300,000 in savings retained in your offset account. In this example, you would pay absolutely no interest on your mortgage at all.
How does an offset account reduce interest?
When your mortgage is established, the bank will set it up so that interest is calculated on the outstanding balance you owe at the end of each day. The total interest charged for that month is then added together and shown as one interest figure on your statement.
Making one repayment each month means your balance is only reduced once per month. This means your interest is being calculated on a static balance level at the end of every day. You can reduce this slightly by making more frequent payments, such as switching your payment frequency to fortnightly or weekly. Both of these options will reduce your outstanding balance a little more throughout the month, which subsequently lowers the amount of interest the bank is able to charge you.
If you link an offset account to your mortgage and arrange to have your salary and any other income you receive paid into the account, you get the opportunity to reduce your mortgage balance even more frequently. This is because interest on a home loan is calculated daily, so every day you have funds in your offset account, even if you later use them, will help towards reducing the interest payable.
How does an offset account affect your repayments?
If your loan is set up as a principal and interest loan, where some of your repayment amount covers interest charges and some goes towards the principal, the actual amount you pay each month won't change. You will still pay the same monthly amount to your bank.
However, the ratio of principal to interest will change, depending on how much cash you have in your offset account.
Let's work on some actual figures, assuming that you have a mortgage of $300,000 at 6.5% over 30 years.
Principal and interest payments
Your minimum monthly repayments will be $1,896.20. Of that total amount you pay, $1,625 goes towards your interest charges while a measly $271.20 pays down your mortgage balance a little during your first month.
Now, if you had $10,000 sitting in an offset account your repayment would still be the same at $1,896.20 per month. The difference is that you would only pay $1,570.83 in that first month, with $325.37 coming off the mortgage balance.
The cash you had sitting in your offset account actually reduces the amount of interest you pay each month so that the amount that goes towards your mortgage balance is increased. As a result, you end up paying your mortgage off much faster, as this has a significant compounding effect over time.
If you have opted for interest-only payments on your home loan, your repayments may be affected by the amounts you have in your offset account. Remember, the amount of interest you're charged is calculated on your daily mortgage balance minus the funds in your offset account.
By leaving funds in your offset account as long as you can before paying bills and living expenses, you subsequently reduce your mortgage balance each day. This means the interest payment you make at the end of each month will be reduced.
Will I earn interest on the savings in my offset account?
You aren't paid any interest for the cash you leave sitting in your offset account. However, you are reducing the amount of interest you pay on your mortgage based on how much you have in the account.
When you think about it, the rate of interest charged on a mortgage is higher than the interest rate you'll earn on your cash sitting in a savings account, so your cash is actually working harder for you in an offset account.
Let's assume you have $10,000. If you put that into a savings account you might earn 4.5% interest on your savings. That's $450 per year in interest earnings that you have to declare to the tax office and then pay tax on.
By comparison, let's put the same $10,000 into an offset account where you're paying 6.5% on your mortgage interest. That's $650 per year in interest charges you don't have to pay, so you're saving money.
Disadvantages of an offset account
- Offset accounts are usually offered on full featured home loans and some of these loans can have higher interest rates or fees attached to them than a basic home loan.
- The offset account itself may have an account-keeping fee attached to it.
- Finally, be sure you know the difference between a partial offset account and a 100% offset account. A partial offset account differs in that it will only offset a percentage of the balance in your offset account, not the full amount.
Why not just pay extra on your mortgage?
There are benefits to keeping money in your offset account as opposed to your home loan. The first of which is that funds can be kept in your offset account and then used as you would with a debit card. This means you could have your salary deposited into your offset account and then get the benefit of lower interest charges every day you don't use your money. Also, accessing money through a redraw facility can come with minimum redraw amounts and fees, which might make an offset account more attractive than making extra repayments.
If you ever need to access your extra funds in the future to pay for unforeseen expenses or unexpected bills, you may need to redraw them from your mortgage. Some banks will charge you a redraw fee that you wouldn't have to pay if you simply withdrew that cash from your offset account. There are also some banks that will limit the amount of money you can redraw with each transaction. This may mean you end up redrawing more than you really wanted to, which costs you more in interest in the long run.
Let's say you decide to put all your savings into your mortgage in an effort to pay it off quicker. You do this for a few years and then you decide you need a bigger home for your family, but you don't want to sell your existing home. Instead, you want to turn it into an investment property. So you redraw your extra payments out of your mortgage and pay them onto the mortgage for your new family home. This keeps your new mortgage lower and raises your investment loan a little.
If you redraw those extra funds you paid into the mortgage to use as a deposit on your new home, you may face some significant problems when tax time rolls around. By redrawing funds out of your original mortgage and paying them into your new mortgage, you effectively withdrew cash out of your investment for personal use. This is frowned upon by the tax department, as the old loan you now want to use as an investment needs to stay at the balance it was at when you stopped living in it. That's the tax deductible balance the ATO will work on.
Yet, if you left those extra funds sitting in an offset account and then withdrew them to pay the deposit on your new home, the original loan remains untouched. You can reduce your new family home mortgage, but you also get to leave your investment mortgage at a higher balance to maximise your tax deductibility.
Bill has a home loan of $300,000 and has worked hard to pay $50,000 in extra payments into the redraw facility. If he purchases a new home and turns the original house into an investment property, his investment loan amount for tax purposes will be $250,000. Even if he withdraws that $50,000 from his redraw facility and raises his mortgage to $300,000, the tax office will consider that he withdrew $50,000 from it for personal use – not investment use.
Maximising the savings you have in an offset account
If you're disciplined with your money, you may have an opportunity to maximise the amount of cash you leave sitting in your offset account each month. Many banks allow you to package up your banking products to receive discounts on account fees and charges.
You might have the chance to package up your mortgage with your offset account, along with a handy credit card, all under the same annual fee.
The majority of credit cards these days come with interest-free days attached. This means you can use the bank's credit to pay for your bills, living expenses and other costs at the beginning of each month. As long as you pay off the whole balance before the due date, you won't be charged interest on those purchases.
If you have your entire salary paid into your offset account each week or fortnight, you're increasing the amount of savings you have in your account. At the same time, you're reducing the amount of interest you pay on your mortgage.
When you add in the benefit of paying for all your bills and expenses on a credit card with interest-free days, you get to leave your salary sitting in the offset account for a longer period of time. When the credit card bill is due, you withdraw the funds from your offset account and pay it down to zero.
As a result, you pay even less interest on your mortgage and you pay absolutely no interest on your credit card. If you can coordinate your finances the right way, this can be an extremely powerful tool.
As mentioned, discipline is key here. It's important that you always spend less on your credit card each month than you earn. The amount of salary and other income going into your offset account needs to cover your mortgage repayments and your entire credit card bill each month, or you end up paying more interest than you really need to.
Offset accounts and fixed rate home loans
Offset accounts are commonly associated with variable rate home loans, but the competitive nature of the home loan market means this feature is available with some fixed rate home loans. These home loans can provide the stability of a fixed interest rate and reduce the amount of interest you pay at the same time. While this repayment method is suitable for borrowers who have just entered the market, such as first home buyers, using this home loan as a hedging strategy may not be as effective. Variable interest rates fluctuate according to economic conditions and unless you’re an economic expert, predicting when interest rates fall or rise is no easy task. Either way you’ll still have the benefit of the offset account to reduce your principal.
Is an offset account the best option for you?
Offset accounts are considered to be deposit products. Therefore, they are considered investment accounts. In order to determine whether an offset account is better for you or not, you should not take any information provided within this article as financial advice. Rather, you should discuss your situation with a licensed financial advisor and work out whether an offset account might be right for your own personal financial situation or not.