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:
- Keep making the same repayments, which then becomes like method #1 as you’re effectively paying more than minimum, or
- 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.
- Can I comfortably keep making my repayments at this rate?
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
- 3.97% 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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Lacey Filipich is the co-founder and director of Money School. She helps parents raise financially savvy kids and helps adults get on top of their finances. Connect with her on LinkedIn and follow the Money School Facebook page to learn more.
Nice article, confusing graph!
I found this useful, thank you. I am also wondering about the pros and cons of keeping hold of existing shares and using the dividend monies to pay down the mortgage versus selling the shares and using the proceeds to pay down the mortgage instead. If you have $100K in shares and they return – say – 6% a year, is it better to sell them and throw the $100k at the mortgage, or to throw the $6k dividend at the mortgage every year? I appreciate that there are variables such as the capital gains tax liability when you sell, and the fact that share prices are unpredictable therefore the dividend yield is unpredictable.
Hi Nick, Great question! And one I can’t give you a simple answer for sorry.
I think of this as having ‘one in the hand, two in the bush’ potential. Over decades, you would expect the growth of the shares to well outearn the interest rate – but who has a crystal ball and can tell? The interest on the mortgage is guaranteed. The returns on the shares are not. If uncertainty stresses you out, you might prefer to have the certainty of having paid more off the mortgage (taking the capital gains etc into account when you run your calcs, as you alluded to).
Also depends on how much you’re earning relative to the mortgage repayment and job security – if you’ve got a decent wage and you’re feeling like your job is reasonably secure, you might be more confident keeping the shares and just using dividends to speed up mortgage repayment, rather than paying off a lump sum using the sale of the shares.
Sorry that’s not helpful – just some more points to consider 🙂 Cheers, Lacey
Your spreadsheet suggests that interest rates are the same for all the mortgage types. This is not the case. Interest rate on offset mortgages are higher than standard. You need to take this into account.
That’s interesting Steve. I’ve always been quoted the same interest rate for a mortgage with or without the offset. There may be lenders who differentiate, but it’s not universal. The advantages offered by a bank that differentiates would have to be pretty impressive to accept that. But thanks for your comment, good to be aware of it.
I am looking to build a house and going thru keystart for the initial home loan.
I am hoping to a tax refund say 10k back this financial year
Loan is say 350k.
What should I do in my first years as keystart don’t have an offset account.
Should I saving my tax refund till i refinance with a bank or should i pay in full to the home loan in the first year?
I was looking to refinance with offset account.
Would it better to pay the principal off with the money.
Or put it down on the offset account
Or should i split it between half principal payment and adding to offset account
Would be good to get an example of a lender who provides exactly the same interest rate with or without offset facility…
Hi Lacey, If I already have $30k in redraw, (also have off-set account) would you recommend taking the redraw funds and depositing into the off-set account? Thank you
Cleared up a lot of my confusion regarding offset accounts apposed to redraw etc – thank you
So our scenario is I’m going to put all my super into mortgage account reducing it to zero, but want to be able to redraw in emergency, but if I leave the balance at zero, I am presuming no interest will be payable anyway…however I note from one of your comments there is a possibility that the bank may finalise the account? Or should we leave a balance of say $5000 (presumably only paying interest on“ $5000? Or at the end of the day should we just deposit all we have into offset? Gain in effect reducing the balance to zero and therefore paying no interest?
What if you made a small payment every day towards your mortgage – totalling your monthly P&I repayment obligation. Would that save you money and time in the long run? Assuming interest is calculated daily.
Hi JK, in most cases interest will be charged monthly, so it doesn’t reduce the amount of interest charged unless you pay more in total over the month. Hope that makes sense. Cheers, Lacey
If you change from monthly to fortnightly repayments, wouldn’t the bank make you pay less so that it still takes the same time period to pay off?
The bank ‘minimum required’ repayment will drop. Usually it’s up to you to decide what you’ll repay and as long as it’s equal to or more than the minimum you’re fine – generally they can’t make you stick to minimum (I’m yet to see an example where they can, but I am willing to be corrected!) The trick is to find out the min monthly repayment, divide by two and ask to make that number your fortnightly payment instead of defaulting to their calculated minimum fortnightly repayment. It’s like sneaking in a 13th month each year, which is why it accelerates paying off your loan. Cheers, Lacey
We are in the process of working out what we want to do. The options to choose.
We already pay back a bit more than we need to. We are also on weekly repayments and seeing the benefits from that.
We are currently using offset accounts but considering a lump sum payment. It seems we might as well stay with offset accounts as it is technically the same interest being paid.
But I am wondering if it is still worth it to pay the lump sum for a couple of reasons.
1. Putting the money into the loan means we own more of our house in the banks eyes. Which could be good if we decide to go for another loan for an investment property.
2. While we are using our savings accounts as offset accounts, we are not earning any interest on our savings. By lump sum paying it, we would be able to have interest earnings on those savings accounts again while we are building up enough to make another lump sum payment.
But I am not sure if these are good enough reason to lump sum pay.
Good explanation more money in the offset sounds the best for me.
I have been given a divided loan. One is a fixed loan for 270,000 (no offset) and one is an offset loan for $20,000. I am so confused! I have $20,000 lump sum that i can pay off the the offset loan. Is that a good idea? How should i go about my larger fixed loan? Any help would be great!
Hey Lacey,
great explanation, thanks!
I have a question, though.
Say that my minimum repayment is $1500 and I have $50000 in an offset.
If I have no offset and on a specific month the interest owed is $850. This makes the principal $650.
If I have the offset the reduces the owed interest by $150 (let’s say) then the interest owed will be $700 and the principal $800.
Now, will these extra $150 that have been put towards the mortgage count as extra contributions considered that if I did not have the offset it would have been only $650 towards the principal for that month?
And, if so, do they count for the available balance that can be redrawn?
Hope my question makes sense.
Thanks
Andrea
Hi Lacey, great article!
I have a question though: I have paid the balance on my mortgage account some 3 years ago so it’s zero since then. I have an offset account with a reasonable balance now so I was thinking of closing the mortgage account for good and discharging it. My question is, the bank applies the “Home Loan Scheduled Repayment” to the available for redraw balance on the home loan account so that available amount is being reduced overtime. Is that correct? So the bank reduces the available balance for redraw overtime?
Thank you for this Lacey, your model makes perfect sense and the explanation is clear and thorough. Saves me building my own model and walking my engineering wife through it!
It 100% answered the question I had on maintaining an offset vs increasing repayments – the outcome is the same! (our bank offers the same interest rate regardless of arrangement)
Thanks again – your efforts to increase financial literacy amongst us are very much appreciated.
Nik
Great explanation – a further question, please.
What will reduce the loan term:
A) Keep money in offset & switch to fortnightly
B) Keep money in offset & pay monthly
Cheers,
This doesn’t factor in the low interest rate you would receive (lose!) by placing said $100k into an offset account. The bank makes a lot more out having an extra $100k sitting in their coffers to place into investments.
Better long term option is put all your spare cash into an index fund, which returns on average 8.8% over the long term. Pay your mortgage at the minimum, and use the index fund to balance the difference after the 30 years.