The benefits of utilising an offset account

In this article, I’ll show you how to earn twice as much as someone earning interest in a high yield account, and pay no tax while doing so!

It’s pretty hard for me to get excited about a banking product, but the humble offset account is literally my favourite way to save money.

An offset account works in the same way as an everyday bank account, however it has one extra feature that makes it so much better.

When you have a loan with a bank and utilise an offset account, interest is only calculated on the net balance - i.e the amount outstanding on the loan less the amount you have in your offset account.

Here’s an example:

Joe Bloggs has a home loan for $500,000. He has also saved $45,000 in his everyday account, which he setup as an offset account. Rather than the bank calculating his interest on his $500,000 loan, his bank will instead calculate interest on $455,000, i.e. the $500,000 loan less his $45,000 in savings.

This provides real world savings and is an excellent strategy for saving money and paying off your home loan faster.

Let’s say Joe is being charged interest of 4% on his home loan. Using a simple interest calculation, the interest on a $500,000 loan would be $20,000 per year.

Using the offset account feature, the interest is reduced to $18,200. That’s a saving of $1,800 per year and all you need to do is ask your bank for this feature.

Even if Joe never saved any more money, that’s a saving of $18,200 over 10 years just by having your bank account setup correctly.

The good news continues from here, as the savings are tax free.

Contrast this to investing into an interesting bearing account...Not only would the returns be lower at say 2%, you would likely have to pay tax on these earnings.

This further dilutes the returns and makes offsetting much more beneficial for growing your wealth.

Interest saved using an offset account 4%

Tax payable on savings 0%

After tax return 4%

Interest earned on an interest bearing account 2%

Tax payable on savings, as high as 47%

After tax return 1.06%

I know which one I’d prefer.

If you have a home loan and cash that you don’t know what to do with, there’s no better place to park the cash than in an offset account.

Further good news continues from here.

Another reason that offset accounts are so good is that technically you aren’t repaying the loan, you are just offsetting the loan. The offset account remains separate from the loan.

Why is this important?

Repaying a loan is not always the best idea, especially when you can instead offset the loan. I would much rather offset a loan and pay less interest, than repay the loan prematurely.

There are several reasons for this. Firstly, because the cash is in my bank account, I have control over that account and can use it as required. If the loan were instead repaid, I’d need to contact my bank to redraw the original loan. In life, you never know when you will be hit with surprises, so I like to have quick access to my cash if need be.

The second issue occurs when you have repaid a proportion of a loan, and redraw on the loan.

The ATO have provided Tax Ruling 2002/2, which sets out their interpretation of what happens when a loan is repaid.

Effectively, the ATO takes the view that what the loan is used for determines whether the loan is deductible or non-deductible. So if you borrow say $400,000 to buy an investment property and $50,000 to buy a boat, the $50,000 proportion of the loan is not-deductible.

A common problem can occur when you accelerate repayment of your home loan, and at a later point in time, wish to convert your home to a rental property. This is best illustrated by way of an example:

Mrs Bloggs buys a property for $500,000. She puts down a $100,000 deposit and therefore has a loan for $400,000. Overtime, she has paid the loan down to $150,000 outstanding. In the future, she decides to buy her dream house and convert her current home to a rental property . In order to afford the new house, she has to redraw on her original property loan. She proceeds to redraw $250,000.

What has happened here is that there are now two components of Mrs Bloggs’ loan. The first $150,000 relates to the original purchase of her first property. Once she starts renting this property, the interest on the loan will be tax deductible.

The drawdown of $250,000 however relates to the purchase of her new home, and as we know, in Australia, interest on your home loan is not deductible.

When Mrs Bloggs prepares her tax return, the interest on her $150,000 loan is deductible, as it relates to the acquisition of a property that is now for income producing purposes. If the interest rate is 4%, she will include a deduction in her return of $6,000.

Let’s contrast this to someone who uses an offset account.

Mrs Wise buys a property for $500,000. She puts down a $100,000 deposit and therefore has a loan of $400,000, which she decides to set up as interest only. When she negotiates the loan, she also organises an offset facility.

She builds up extra cash savings in the offset account. Overtime, she has built up $250,000 in her offset account and the outstanding loan balance remains at $400,000. Her overall loan position after offsetting is still $150,000, but the extra savings have been placed into an offset account instead.

Mrs Wise finds her dream house and needs to put a deposit down, she proceeds to use the $250,000 in her offset account. Because the original loan has never been paid down, the proportion of her loan that relates to her former home which becomes her investment property is still $400,000. Mrs Wise goes to her accountant to prepare her annual tax return and includes an interest deduction of $16,000 in her tax return (4% of $400,000).

Contrast this with the first example, and Mrs Wise receives an additional $10,000 in interest deductions, all perfectly legal and all because she set up her loan facilities correctly.

The use of the offset account plays a key role in keeping as much of the original loan deductible, and not contaminating it with private, non-deductible transactions.

Overall, she will still pay the same amount of interest, it’s just that in the second example, more of the interest relates to her investment property rather than a non-deductible home loan.

Offset accounts work perfectly for people that are disciplined to not spend the money. However, the ease of access can be too tempting for some people.

From a strategic financial perspective, if you like to accelerate debt reduction, utilising the offset account is a great way to do this as you could effectively pay off your loan in the offset account, but still have direct access to those funds in an emergency.

It’s hard to think of a better way to use cash effectively and pass the sleep at night test.

What about a Line of Credit?

In the world of lending, there is a competitor to the offset account and that’s a Line of Credit.

A line of credit is similar to an offset account in that you are granted your original loan amount, say $400,000, and you are able to use this account like an everyday bank account. You are often encouraged to deposit your wages into this account and to pay for your everyday expenses from this account. The idea is that your savings over time will reduce your loan quicker.

But the line of credit is horrible if you wish to later convert your home loan to a deductible loan in the future. That’s because each wage payment in reduces the balance of your loan, so you are effectively reducing the deductible proportion of the loan.

Unfortunately, in my time as an accountant, I have seen people being recommended the Line of Credit by their mortgage broker or bank, only to find that when they wish to convert their home to an investment property, almost none of the original loan is outstanding, all because they repaid the original loan but redrew the loan for private, non-deductible purposes. Ouch.

Even if you aren’t intending to convert your home to a rental property, it still makes sense to utilise an offset account, because you never know what the future holds.

If you have the discipline to not frivolously spend the money built up in your offset account, there’s no better way to hold cash than in an offset account.