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An "Offset Account" and how to use it to your advantage

Marty McDonald - Friday, August 26, 2011

An offset account can be a great tool that can be used by both home and investment loan borrowers. From saving interest on your home and paying off your home sooner to tax planning for investors an offset account is truly a powerful tool if used correctly.

An offset account and how they work

An offset account, interest offset account, mortgage offset account and offset home loan are all interchangeable terms. They all describe a separate account which is linked to a loan and which offsets the interest charged to that loan. Hence the general term offset account!

Perhaps the easiest way to describe how an offset account works is via an example. Say today you owed $350,000 on your home loan and you had $5000 in your offset account as per the diagram below. Your lender would calculate the interest on your loan for today based on the amount owing on the loan less any offset balance. In the example below the interest calculated would be based on a net balance of $345,000.



Consider another example to illustrate how an offset account works....assume you owed $350,000 on your loan and you also had $350,000 in your offset account (would be nice!). In this scenario you would not be charged interest at all.

Calculating interest savings using an offset account

Interest on a home or investment loan is almost always calculated daily. Therefore if you know what the daily balance of your offset account will be you can calculate the interest saving that the offset account will give you. You will also have to know the interest rate that you are paying on your loan.

So for example say you have a loan with an interest rate of 7% pa and you estimate that you will have on average a balance of $10,000 in your offset account per day.

                 $10,000 × 7% pa = $700 pa savings

Is an offset account a good idea?

You can see from the above example that if there is not a significant amount of money sitting in your offset account each day on average it is not going to have much impact / produce much interest savings. Therefore before deciding that you need an offset account you should consider if it is going to be worth paying any extra fees or paying a higher interest rate to get one linked to your loan. Sometimes it may still be beneficial to take a more expensive loan with an offset account if you plan to use that offset account for tax planning purposes. As discussed below.

As an offset account is a deposit product and it is therefore the realm of a licensed financial adviser to advise on the appropriateness of an offset account for your situation. I have attempted to outline some of the advantages and uses of offset accounts in this post but please seek qualified financial advice.

How loan repayments are affected by your offset account balance

While money in your offset account will always offset the interest you would have paid on your loan your minimum repayments will be affected by the type of loan repayments you have.

a) Principle & interest loans

If your loan repayments are on a principle and interest basis i.e. your loan balance is reducing your repayments won't change regardless of how much cash you have in your offset account. What will happen in this case is more of your repayment will go to the principle of your loan i.e. you will be paying off your loan faster. Say for example you had the $350,000 loan as above. If you then also had $100,000 in your offset account you would be paying interest on only $250,000 however repayments would be based on $350,000. That means more of your regular fortnightly or monthly repayments would be going to pay off your loan.

b) Interest only repayments.

If your loan has true interest only repayments then the monthly repayments on your loan will be something like this: (The loan balance - Offset account balance) × current % ÷ 12 = monthly repayments

c) Interest based repayments

A few lenders have interest based loans whereby the minimum repayments are set at whatever the monthly interest repayment would on the loan be assuming there was no offset account balance. For these types of loans the offset account still offsets your interest but repayments will remain constant. In effect these loans act more like principle and interest loans but with lower minimum repayment required as any offset benefit will be paid off the principle of your loan.

Funds in an offset account versus paying funds into your loan

Mathematically paying funds into your loan has the same effect as if those same funds were sitting in your offset account. Using the above example if you decided to pay the $5000 into your loan rather than leaving in your separate offset account the interest for the day would still be calculated based on $345,000. There is no difference mathematically to the interest calculation for that particular day. However the way those funds can be treated if redrawn for example is quite significant.....(see below).

Tax deductible of loan redraw versus funds in an offset account

There is one fundamental difference between redraw and offset accounts and that is funds paid into a loan and then redrawn for non investment purposes will affect the tax deductibility of the loans interest going forward where as funds paid into an offset account and subsequently used (for whatever purpose) do not affect the loans potential for tax deductions going forward.

If the loan is an investment loan or if the intention is to convert it to an investment loan in the future then paying funds into a loan then using redraw for personal purposes is a mistake that can't be undone.

For example: Imagine you had a home loan balance of $700,000 and you paid $200,000 into the loan thereby reducing the amount owing to $500,000. You then decided to redraw that $200,000 for non investment purposes. Your loan balance would again be $700,000 and the interest on the loan would be calculated accordingly.

However and this is the kicker...say you decide to turn the underlying property into an investment. In this scenario the $200,000 redrawn would not be tax deductible as the funds were used for non investment purposes. Effectively meaning you could only claim an interest deduction on part of the loans balance ($500,000) going forward.

If instead of paying the $200,000 into the loan the funds were placed in an offset account then potentially the interest on the full loan balance of $700,000 could be claimed going forward. What seems like a slight difference is actually significant which could cost  you thousands of dollars in lost deductions over many years.

Taking this example say you did the $200,000 redraw instead of placing the funds in the offset account. $200,000 x 6% pa = $12,000 pa in lost interest deductions each year. If you have the property / loan for 15 years then this would potentially equate to losing $180,000 in tax deductions over that time!

Case study: Turning your home loan into an investment loan and maximising future tax deductibility

One  scenario that I see a lot as a broker is a client wishing they hadn't paid down their home loan so much! I know it sounds counter intuitive but bear with me.

Often people buy a home and then a few years later through a combination of paying down their loan, higher property prices (gaining equity) and increased income they are in a position to upgrade. Many people also want to retain their existing home and rent it out thus turning it into an investment property. The only problem with this is they end up with a small investment property loan and usually a much bigger owner occupied loan. From a tax point of view it is almost always better the other way around!

So how can an offset account help with this situation? Well with a bit of foresight (well a lot actually) you could set up your affairs so that you have a home loan with a linked offset account and over the years rather than paying off your home loan with accelerated repayments you could instead build up these savings in your offset account. Your interest bill would be the same. However after many years you would hopefully have a large pile of money in your offset account and most importantly you would have a loan balance that you could still maximise the interest deductibility on going forward.

When you were ready to upgrade you would simply draw the money from the offset account as all or part of your deposit on your new property and your existing loans interest would become tax deductible (with a higher loan balance than if you had paid excess funds into the loan). Remembering redrawing of funds from the loan if you had paid your excess funds into the loan would be considered a new loan in the eyes of the tax man and the purpose of the redrawn funds would determine if the interest on the redrawn funds was tax deductible or not.

An interest only loan would be the optimal set up as the balance of the loan would not decrease over time which would in turn mean you could maximise the potential benefits of this strategy. Most lender allow the first 5 years of a loan term to be interest only. Most lenders will also allow an additional 5 years of interest only period at the end of the first 5 years. So in effect 10 years interest only (of the standard 30 years) is acceptable with most lenders.

Even with a reducing loan balance i.e. a standard loan with principal and interest repayments this strategy would still be much more effective than if excess funds had been paid into the loan itself provided only the minimum repayments are made.

Summary

An offset account can be a really great loan feature. With foresight a budding investor can use an offset account to maximise their future tax deductibility benefits. It can also be said that an offset account linked to an interest only loan is perhaps the most flexible of all loan set ups as it allows for any eventuality.

If you would like to know more about how an offset account could work for you as well as other tricks of the trade please contact me .

 

Thanks for reading,

Marty McDonald

 

About the Author: Marty McDonald is principal of mortgage broker “Mortgage Experts”. Marty specialises in assisting active property investors with loan structuring advice and implementation as well as helping credit worthy borrowers with slightly outside the box income and employment situations. Find Marty on and LinkedIn.

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