How Offset Accounts Can Save You Thousands in Interest
Offset accounts are a powerful tool for homeowners looking to reduce the overall cost of their mortgage and shorten the time it takes to pay off their loan. By leveraging your everyday savings or surplus funds, an offset account can deliver substantial interest savings over the life of a home loan.
This article explains how offset accounts work, explores the key benefits, and provides practical tips to maximise their potential. While the principles apply universally, examples and considerations are tailored for Australian borrowers.
What Is an Offset Account?
An offset account is a transaction account linked to your home loan. The balance in this account is used to “offset” the loan balance when calculating the interest you owe. For example, if you have a home loan of AUD 500,000 and an offset account with a balance of AUD 50,000, you’ll only be charged interest on AUD 450,000.
Unlike a traditional savings account, an offset account does not earn interest. Instead, the savings lie in the reduced mortgage interest, which is typically much higher than the interest rate on savings accounts.
How Does an Offset Account Work?
To understand how offset accounts save money, consider how home loan interest is calculated. Interest is usually charged daily based on the outstanding loan balance and then added to your repayments monthly. An offset account reduces the daily balance, meaning less interest accrues.
Example:
- Home loan amount: AUD 500,000
- Interest rate: 5%
- Offset account balance: AUD 50,000
Without an offset account, the interest charged on the full loan balance would be approximately AUD 25,000 annually. However, with an offset balance of AUD 50,000, the interest is calculated on AUD 450,000, reducing the annual interest to AUD 22,500. This equates to a saving of AUD 2,500 in just one year.
Key Benefits of Offset Accounts
1. Significant Interest Savings
Offset accounts can reduce the amount of interest you pay over the life of your loan, potentially saving you tens of thousands of dollars. These savings can be reinvested into your loan repayments, accelerating the time it takes to pay off your mortgage.
2. Shortened Loan Term
By reducing the interest portion of your repayments, a greater proportion of each payment goes towards the principal. This can significantly shorten your loan term, often by several years, resulting in even greater savings.
3. Tax-Free Savings
Unlike interest earned on savings accounts, which is taxable, the savings generated through an offset account are effectively tax-free. For borrowers in higher tax brackets, this makes offset accounts an even more attractive option compared to traditional savings.
4. Liquidity and Flexibility
Offset accounts provide liquidity, meaning your funds are easily accessible for everyday expenses or emergencies. This flexibility is particularly beneficial for homeowners who prefer to maintain financial freedom while reducing their mortgage costs.
5. Ideal for Higher-Income Borrowers
For borrowers with higher incomes or significant savings, offset accounts are a highly effective strategy to minimise interest costs while retaining access to their funds.
Full Offset vs. Partial Offset Accounts
Offset accounts come in two main types:
Full Offset Accounts
These are the most common type and work as described: the entire balance of the offset account reduces the loan balance for interest calculation purposes.
Partial Offset Accounts
In a partial offset account, only a portion of the account balance is used to offset the loan balance. For example, a 50% partial offset account would consider half of your savings to calculate the reduced interest.
While partial offsets still provide savings, they are less advantageous than full offset accounts. Borrowers should compare the terms offered by different lenders to ensure they maximise the benefits.
Maximising the Benefits of an Offset Account
To make the most of an offset account, borrowers should adopt strategies that optimise their savings and repayment structure. Here are some practical tips:
1. Deposit All Income into the Offset Account
By depositing your salary and any additional income directly into the offset account, you can immediately reduce the loan balance used for interest calculations. Even if these funds are spent later in the month, they will still reduce interest in the short term.
2. Use the Offset Account as Your Primary Account
Make the offset account your main transaction account for everyday spending. This ensures that any available funds contribute to interest savings for as long as possible.
3. Minimise Withdrawals
While the funds in an offset account are accessible, minimising withdrawals can maximise the savings effect. Use budgeting strategies to limit unnecessary spending and keep more money in the account.
4. Combine with a Credit Card for Expenses
Some borrowers use a credit card for daily expenses and pay it off in full each month. This allows them to keep more funds in the offset account for longer, maximising interest savings. However, this strategy requires disciplined financial management to avoid accruing credit card debt.
5. Make Additional Repayments
Any additional repayments you can make towards your loan will further reduce the principal and complement the interest savings from the offset account.
6. Consider Lump Sum Deposits
If you receive a windfall, such as a bonus or inheritance, consider depositing it into your offset account. Even a short-term increase in the balance can result in noticeable interest savings.
Offset Accounts vs. Redraw Facilities
Borrowers often compare offset accounts with redraw facilities, which allow you to make extra repayments towards your loan and withdraw them later if needed. While both options can reduce interest costs, they have key differences:
- Flexibility: Offset accounts provide more immediate access to funds, while redraw facilities may have restrictions on how often or how much you can withdraw.
- Tax Implications: For investment loans, offset accounts offer tax advantages as they don’t technically reduce the loan balance. Redrawing funds, however, could complicate tax deductibility.
Borrowers should assess their financial priorities and preferences when deciding between the two.
Are Offset Accounts Right for Everyone?
While offset accounts are highly beneficial, they may not suit every borrower. Here are some considerations:
- Loan Type: Offset accounts are typically available with variable-rate loans. Borrowers with fixed-rate loans may need to explore split loan options if they want an offset feature.
- Account Fees: Some lenders charge higher fees for loans with offset accounts. It’s essential to weigh the potential interest savings against these costs.
- Savings Balance: Offset accounts are most effective for borrowers who can maintain a substantial balance. For those with minimal savings, the benefits may be less pronounced.
- Lender Offerings: Not all offset accounts are created equal. Borrowers should compare features, fees, and terms across different lenders to find the best fit.
Real-World Example: How Much Can You Save?
Consider a borrower with the following details:
- Loan amount: AUD 400,000
- Interest rate: 5%
- Loan term: 25 years
- Offset account balance: AUD 20,000 (maintained consistently)
Without an offset account, the total interest paid over the loan term would be approximately AUD 300,000. With the offset account, the borrower saves around AUD 30,000 in interest and reduces the loan term by nearly two years.
Potential Pitfalls to Avoid
While offset accounts offer significant benefits, borrowers should be mindful of potential pitfalls:
- Overestimating Savings: Borrowers with low or fluctuating offset balances may not see substantial savings.
- Neglecting Fees: Higher fees for offset accounts can erode the financial benefits if not carefully managed.
- Lack of Discipline: Easy access to funds may lead to unnecessary spending, reducing the effectiveness of the offset strategy.
Offset accounts are a versatile and effective tool for reducing home loan interest, providing borrowers with the opportunity to save thousands of dollars while maintaining financial flexibility. By understanding how offset accounts work and adopting strategies to maximise their potential, homeowners can significantly reduce the cost of their mortgage and achieve financial freedom faster.
While offset accounts may not suit every borrower, they offer unmatched benefits for those with consistent savings or the ability to maintain higher account balances. Before committing, borrowers should evaluate their financial situation, compare lender offerings, and seek professional advice to ensure they’re making the most of this valuable feature.
By taking a proactive approach, you can leverage an offset account to not only save money but also gain greater control over your financial future.
