Should I pay down my mortgage or use an offset account?

Once every six months or so, my husband brings up paying off a chunk of our mortgage in a lump sum and I argue in favour of the offset account. The discussion that ensues is a well-rehearsed dance:

Me: “But if we pay off a lump sum, if we need that cash we’ll have to redraw, and maybe the bank won’t let us.”

Hubby: “But if we pay it down, we can drop our mortgage repayments.”

Me: “What’s the point in that? You’ll be charged the same amount of interest either way.”

Hubby: “How can that be? Surely I’ll be charged less interest if I pay it off?”

Me: “You’re not paying interest on that chunk now. Everything in the offset, is OFFSET – you don’t pay interest on it!”

…at which point our tiny brains explode and we abandon the discussion. Until the next time.

When the last ‘next time’ came around, I decided to settle this debate once and for all in the same way two engineers have always settled arguments since time immemorial.

I created a model.

With clearly stated assumptions.

In a spreadsheet.

(No, not Matlab – I’m not THAT sad.)

We finally hashed it out and have landed on our strategy for our home, which is:

  • We will keep the money in the offset.
  • When we get over $250,000 in the offset and if we’re feeling we won’t need the money for 6mo+, we will pay a chunk off the mortgage to bring the offset account balance back down to $250,000.
  • We will keep paying the mortgage at the original home loan rate for as long as we can – even if we pay down a lump sum.

That’s the strategy we will follow, but it may not be the right one for you. To help you decide what it right for you, I’ve written the following detailed blog. You can grab a copy of the spreadsheet I used for the calculations here.

But first things first: how does this offset account thing work anyway, and why should you care?

You should care because of interest.

How interest works on a home loan

If you have a mortgage, you are being charged interest by the bank each month. To gauge how much this is: most loans that are standard terms (25 – 30 years) will mean you pay off twice what you borrowed. So, your repayments over time amount to ~50% interest and 50% principal.

As you make your regular weekly, fortnightly or monthly payments you’re paying off a bit of what you owe, which reduces the amount of interest you will be charged.

When you do the calculation at the bank, they tell you an amount you’ll pay each month, every month, until the loan is discharged. It’s a regular payment, always of the same amount. But that’s not how the interest is charged – it’s not linear. You’re charged most of the interest in the first 10 years of your 25-30 year loan, during which time the principal (the amount you owe) remains depressingly high. But soon enough the scale tips, and you’re paying off decent amounts of principal and the interest charged is dropping.

It is in your interest to reduce that interest charged as soon as you can, especially on your home loan as this has no tax benefits in Australia.

Ways to reduce the interest you pay

There are three options to pay less than the amount of interest due on the full term of your loan:

  • pay more than your minimum monthly repayment,
  • pay off a lump sum, or
  • use an offset account.

Method #1: pay more than minimum repayments

One slow-and-steady way to reduce the interest you are charged is to add more to your regular payment. An extra $10 or an extra $1,000 on top of your minimum repayment has the same directional effect: less interest charged and paying off the loan quicker. It’s just a matter of scale: the more you pay, the quicker the loan comes down.

This has an effect on cash flow. You have to find that $10 or $1,000 (or whatever it is for you) from your current income.

Another subset of this option is to switch to fortnightly repayments that are half the value of a monthly repayment. This is like making 13 monthly repayments in the year instead of 12. It’s my favourite sneaky way to get ahead on mortgage payments.

Method #2: pay off a lump sum

Sometimes, you may find yourself with a chunk of change in the order of thousands of dollars. Perhaps you sell a toy (e.g. jet ski, boat), or you get a bonus at work, or you get some inheritance. You could use that chunk to pay off a part of your mortgage in what’s called a lump sum payment.

This reduces what you owe, and therefore the interest you’re charged. Because the time period of the loan remains the same but the amount you owe is less, the minimum repayment required drops.

You could then do one of two things:

  1. Keep making the same repayments, which then becomes like method #1 as you’re effectively paying more than minimum, or
  2. Ask the bank to reassess your payment for the new amount, dropping your repayments to the new minimum.

Option 1 results in the least amount of interest charged.

Method #3: Put the lump sum in an offset account

Instead of paying off some of the balance of your mortgage, you could ask your bank to set up an offset account. This is a savings account linked to your mortgage. As the name implies, it offsets the balance on your mortgage and you are only charged interest on the difference between the two. For example:

  • Your mortgage balance is $300,000
  • Your offset balance is $100,000
  • Instead of being charged interest on $300,000, you are only charged interest on $200,000 – the difference between the loan amount and the offset balance.

With an offset account, the loan balance stays the same so the minimum repayments do too. It’s just that you’re charged less interest, so the loan balance goes down quicker as more of your repayment goes to the principal.

So, which is better?

There is no right or wrong here – there’s only what works for you, in your personal circumstances, at this point in your life.

Here’s my quick guide to making this decision:

  • If you don’t have a lump sum saved somewhere: forget the offset and concentrate on upping your regular repayment by a few bucks at a time (PS: you really should have a lump sum somewhere – a nice cushy buffer fund to cushion you through the inevitable shocks of life. Time to get started on that).
  • If you do have a lump sum, answer these two questions:
    • Can I comfortably keep making my repayments at this rate?
      • If not, paying off a lump sum will help drop your repayments.
    • Do I think I might want to access this money again?
      • If yes, you may prefer an offset.

To help you get your head around what happens with the interest, here’s a chart showing a few different scenarios:

Base case (red line):

  • $300,000 loan
  • 97% interest
  • 30 year term
  • $1,427.06 repayment per month

Pay off a bit more (blue line, Method 1)

  • Change to $714 per fortnight repayments

Pay off $100k and keep same repayments OR put $100k in offset (green line, Method 2 part 1 and Method 3)

  • Repayments remain $714 per fortnight

Pay off $100k and drop to minimum repayment (purple line, Method 2 part 2)

  • Repayments drop to $951 per month

 

As you can see, it doesn’t matter whether you pay off a lump sum or put it in an offset; if you keep the repayments the same, you’ll pay the same amount of interest, and it will be less than any of the other options.

What about redraw?

When you make more than the required monthly repayments, you pay your mortgage off faster. The difference between what you have paid and what you needed to pay is usually reported on your mortgage account and will often be treated as available cash. This is called your redraw.

I am occasionally asked whether an offset and redraw are effectively the same thing – after all, both are lumps of cash reducing your interest charges.

I simply get nervous if it’s in redraw. When it’s already paid off the mortgage, it’s in the bank’s hands. If they decide they don’t want you to have what’s in redraw – for example, if they reassess your loan and it falls into a different risk category – they could conceivably keep it.

When it’s in an offset, it’s the same as a savings account. It’s yours, not theirs.


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