An offset account is an incredibly powerful, and severely under-used, way to pay off your home loan faster. If you put your money in a savings account you'll not only earn very little interest but you will be taxed on that interest. Not fun. That's why more and more Australians are putting their money into an offset account. Not only does it save you interest off your home loan (effectively "earning" your home loan rate) but that saving is tax-free.
How does it work?
Your mortgage repayment is simply interest + principal repayment (your actual loan). So the less interest you pay each month, the more you repay your loan, the faster you pay off your mortgage. How an offset account works is simple: you pay less interest because the lender reduces the amount you owe on your mortgage by the amount in your offset account when calculating your interest for the month. Lower interest means more of your payments go towards paying off the loan.
Example - No Offset Account
To show you how offset accounts work their magic, let's touch on how interest is calculated.
Let's assume you borrow $300,000 at 5% with a 30 year long term and monthly payments of $1,610.46. The bank charges interest on your loan daily but charges monthly. Here's how they work it out:
The $1,610.46 mortgage payment is calculated to not only pay this interest, but repay the loan by the end of 30 years. So of the first $1,610.46 payment you make only $360.46 will go towards the loan because $1,250 is going in interest!
But there is a silver lining, the $1,610.46 mortgage payment will not change for the entire loan (unless rates go up). That means, as you pay off your loan, more and more of your mortgage repayment goes towards repaying the loan, rather than interest.
Here's a table showing the break down of your $1,610.46 payment for the first 2 months:
You can see that your total payment didn't change, but because the amount owing in the second month was lower, your interest was lower which meant more of your payment went towards repaying the loan.
Example - With an Offset Account
Offset accounts reduce the amount of interest you owe each month so you can pay off your loan faster.
Let's say at the start of the loan you opened an offset account and put $20,000 into it. Even though you owe $300,000, the bank will only calculate it's daily interest on $280,000. So, using our calculation from above let's work out how much interest you would have saved:
Under this scenario you would only be charged $1,166.67, rather than $1,250, a saving of $83.34 in interest in the first month. That extra $83.33 then went towards paying off your home loan. Let's see the new breakdown:
As you can see, you would have paid off an extra $167.02 without increasing your payments ($1,610.46). The faster you pay off your home loan, the more you save in interest. In fact, you would have paid off your loan over 3 years faster, saving you $33,703.17 in interest.
What about if I make extra repayments?
Extra repayments reduce the amount you owe and have the same effect as the money in offset. Lower loan amount means lower interest which means more of your mortgage repayment is principal.
In fact, if you had $20,000 in offset and could pay an extra $100 per month you would pay off your home loan 6 years faster, saving you $64,878.41 in interest.
Where to from here?
Let me leave you with 3 thoughts: