Time to read : 5 Minutes
Got a bonus from work or sold that jet ski you never use?
Should you throw it straight at your mortgage, or pop it into an offset account?
In my former life as a mortgage broker, I was often asked – what’s the best way? And it’s a very good question.
I’m going to help you understand – when it comes to home loans – how you can break up with your bank faster. We’re going to dive into how an offset account works. But first let me give a quick recap on the interest side of things…
How interest is charged on a mortgage
When you have a home loan, the bank charges you interest every month – but that interest is calculated daily. (Remember this bit – it’s important for later.)
Typically, over a 25-30 year loan term, you’ll pay about twice what you originally borrowed. This is because, at an average interest rate of 6-7%, your repayments cover both your interest payment (the amount you’re charged for borrowing money) and your principal (the amount you’ve actually borrowed to buy your home).
In the early years of your home loan, most of your repayment goes towards your interest charges. As the years roll by and the principal amount you owe decreases, you’ll find that more of your repayment goes towards your loan balance, and less towards your interest payment.
Where should you put extra cash?
Let’s look at what happens when you deploy your extra money – directly into the home loan or into an offset account. Notice any differences?
Method | Effect on interest you owe | Effect on your cash flow |
Make a lump sum payment directly into your home loan | Reduces your interest charges but keeps your repayments the same. | Locks up your extra cash which is now only available via a redraw facility. |
Place extra funds into your offset account | Reduces your interest charges but keeps your repayments the same. | Cash stays accessible in case you need it eg a medical emergency or holiday. |
Now let’s look at each method in detail.
Method 1: lump sum paid directly into home loan
Paying off a big chunk of debt in one go reduces the amount you owe, which means lower interest charges, but there’s no difference to your mortgage repayments.
This method does lock up your cash though. You’ll only be able to pull that money out again if your home loan has a redraw facility.
Be aware: there are often restrictions and costs for accessing your money once you’ve paid it directly into your home loan.
Method 2: adding extra funds into an offset account
An offset account works like a savings account linked to your mortgage. Whatever amount is in your offset account reduces the interest you’re charged on your home loan – because the principal amount you owe is offset by your savings.
How does an offset account work?
Your home loan of $300,000 will be charged interest on that amount.
If you have an offset account attached of, let’s say, $100,000, your lender will only charge you interest on $200,000 (the amount you owe – the amount in your offset account).
You may decide to use your $100,000 at some point (or you may not). The longer you leave it in your offset account, the more you save.
Let’s say, you want to tap into your $100,000 offset account for an amount of $20,000, your lender would start charging you interest on $220,000, as there is still $80,000 in the offset.
Important: your bank calculates the interest you owe them daily. Each day that your funds in this account offset your debt, you’re reducing your interest charges.
Your mortgage repayments remain the same but with less interest being charged, more of your repayment goes towards the principal amount you owe, reducing your debt each month. Plus, your cash remains accessible if you need it.
Here’s a comparison of home loan repayments for a $300,000 mortgage at 6% interest. One home loan has an offset account with $100,00 in it – and one doesn’t.
Can you guess which home loan will be paid down faster?
Loan amount | Monthly repayment at 6% interest | Interest component of repayment | Amount paid off of underlying loan per month |
$300,000 | $1,800 | $1,500 | $300 |
$300,000 (with $100,000 offset) | $1,800 | $1,275 | $525 |
Note: These figures are approximate. Interest rates and repayment amounts can vary.
The interest for the second-listed home loan option is charged on the loan amount ($300,000) minus the amount in the offset ($100,000). So you’re paying interest on $200,000 instead of $300,000 – but your mortgage repayment amount remains the same.
Note: an offset account reduces the amount of interest you’re paying because more of your repayment goes towards reducing the underlying amount you owe on your home. You’ll notice your loan amount decreasing faster – but not your actual mortgage repayment.
Can you get your home loan repayments down?
To get a lower home loan repayment, you’ll need to refinance your home loan at a lower loan amount once you’ve added your savings directly into your home loan (see Method 2 above).
One clever strategy is to save up a reasonable amount in your offset account, then start looking for a cheaper home loan. When you refinance, you can put your offset savings into the deal and reduce the size of your new loan – lowering your repayment (a variation on Method 2).
How much do you need to offset to make a difference?
The saying ‘every little bit helps’ is never more accurate than when it comes to your offset account.
My examples used a $100,000 offset amount but it doesn’t have to be that much to make a dent in your debt.
Each day you hold money in your offset account, you're not paying interest on that portion of your home loan. For example, with a $500,000 loan and $20,000 sitting in the offset account, you could shave off around 2 years from your loan term and save over $62,000 in interest.
If you’re curious to know how refinancing and having an offset account could save you thousands, talk to the experts at Compare Club.
Is there a catch to having an offset account?
Home loans with offset accounts attached are usually more expensive than basic home loans (this is more obvious when you look at the comparison rates). Some offset accounts might also charge you an account keeping fee.
Yes, but… if you’re confident of squirrelling away a hundred dollars or so per month, it’s usually worth doing. Again, this is definitely something to discuss with your mortgage broker.
Bottom line
An offset account allows you to minimise your interest payments, while maximising your financial flexibility.
Paying a lump sum into your loan account can reduce your interest payments in a similar way to an offset account but this locks your money up, which is only accessible via a redraw facility that can be costly.
Banks calculate your home loan interest daily – the longer you leave money in your offset account, and the more money you put in, the more you save on interest charges. And that ultimately means the sooner you can break up with your bank and be home-loan free.
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Financial disclaimer
The information contained on this web page is of general nature only and has been prepared without taking into consideration your objectives, needs and financial situation. You should check with a financial professional before making any decisions. Any opinions expressed within an article are those of the author and do not specifically reflect the views of Compare Club Australia Pty Ltd.
