A lot of borrowers are fixated on the idea of having an offset account.
Apparently, an offset account allows them to save interest. Whenever they have extra money, extra wages, extra savings, they just “chuck” the money into the offset account.
Voilà, they save on interest charges!
This is true, but also not true.
It would be perfectly true and logical if the costs of the 2 alternative loan products are exactly the same. In practice, a loan with an offset account typically attracts a higher interest rate, and sometimes also attracts an annual fee.
Every bank/lender offers their own unique suite of products, but the following scenarios are not uncommon:
- Loan amount: $500k
- Extra savings: $10k
- Repayment: principal & interest repayments each month
- Loan type: owner occupied home loan
- Variable rate with offset account: 2.59% interest rate with $395 annual fee
- Variable rate without offset account: 2.49% interest rate with $0 annual fee (you do get a free “redraw” facility, and you “chuck” your $10k savings into the redraw facility, to bring down the loan balance to $490k)
- Fixed rate without offset account: 1.94% 2-year fixed rate with $395 annual fee (no redraw facility, you keep your $10k in a savings account earning 0.20% interest rate)
Let’s compare the figures:
- Annual charges on the variable rate loan with offset account: (2.59% x around $490k) + $395 annual fee = around $13,086
- Annual charges on the variable rate loan without offset account: 2.49% x around $490k = around $12,201
- Annual charges on the fixed rate loan without offset account: (1.94% x around $500k) – (0.20% x $10k x [1-0.345 tax & Medicare levy]) interest income + $395 annual fee = around $10,082
Clearly, the cheapest loan is the loan with the lowest interest rate, which happens to be a 2-year fixed rate loan. At the end of the 2-year fixed rate period, the borrower can review the various loan products available in the market, and may choose to go under another 2-year fixed rate period if it happens to be the cheapest option, at that time.
Why is the cheapest loan, the loan with no offset account?
This is because the borrower’s savings is only $10k, against a loan amount of $500k. If he/she chooses a 2.59% variable rate with offset account, they are paying the higher rate on the full $500k loan balance, but they only get to save interest on a measly $10k savings balance. Focus on the forest, not the trees.
When would it makes sense to choose the loan with offset account?
A loan with an offset account may make sense if the borrower has $200k savings instead of $10k savings, and they do not want to reduce their credit limit down to $300k (weird, but there are people like that… maybe they know they’re going to need the $200k for medical expenses next year).
With $200k savings, the figures will look as follows:
- Annual charges on the variable rate loan with offset account: (2.59% x around $300k) + $395 annual fee = around $8,165
- Annual charges on the variable rate loan without offset account: 2.49% x around $300k = around $7,470
- Annual charges on the fixed rate loan without offset account: (1.94% x around $500k) – (0.20% x $200k x [1-0.345 tax & Medicare levy]) interest income + $395 annual fee = around $9,833
Clearly, the variable rate loan with offset account is cheaper than the fixed rate loan without offset account. This is because $200k savings makes up a significant proportion of a $500k loan. The $200k savings effectively “earns” a tax-free interest rate equivalent to the interest rate on the loan, if you put it inside the offset account. On the other hand, if you put it inside a savings account, it only earns a measly 0.20% interest rate (and it is taxed too).
The comparison though is not as clear between a variable rate loan with offset account, versus a variable rate loan without offset account (but with a redraw facility).
From the above example, the variable rate loan without offset account is actually cheaper. This is generally the case when the property is an owner occupied property, where you don’t claim tax deductions on the interest charges.
But if you’re going to rent out the property later, and you’re also likely to access the redraw for a personal purpose (i.e. not for tax-deductible investment or business purpose), it may make sense to choose the more expensive loan which has an offset account. This is because, if you “chuck” your $200k into the redraw facility, and then next year you take out the $200k again to pay for your personal medical expenses, you can only claim a pro-rata tax deduction for the $300k portion of the loan, rather than the full $500k.
Your figures next year will look as follows (next year = the property becomes an investment property, and you spend your $200k on personal medical expenses):
- Annual charges on the variable rate loan with offset account: [(2.59% x around $500k) + $395 annual fee] x [1-0.345 tax & Medicare levy] = around $8,741
- Annual charges on the variable rate loan without offset account: [2.49% x around $500k] – [2.49% x around $300k x 0.345 tax & Medicare levy] = around $9,873
So, in the second year, the loan with offset account is cheaper on an after-tax basis. In the third year, it will still be cheaper if your situation hasn’t changed. In the fourth year, it will still be cheaper again. So, across the 4 years combined, the loan with offset account will become much cheaper, if your situation hasn’t changed…
To find out which loan is the better pick, you would really need to predict your future to the best of your ability. Predict your savings level, whether you’re likely to rent out the property, and whether you’re likely to redraw your loan or use your savings for a personal purpose which is not tax deductible.