Friday Q & A – Redraw vs offset account
What’s the difference between a redraw facility and an offset account?
Interest on a home loan is calculated on the outstanding balance so the lower that balance the more interest you save.
Most home loans allow you to make additional loan repayments and these additional repayments reduce your loan, save you interest, reduce the time to repay your loan and become available to “redraw”. This ability to redraw means that the money you put into the loan isn’t “lost” and you have the ability to take it out again should you need it e.g. pay bills, buy a car etc.
Many home loans also offer an offset account and this is effectively a bank account that doesn’t earn interest rather it “offsets” the loan and from an interest calculation point of view, effectively reduces the loan as if you had made additional repayments.
So what’s the difference?
From an interest saving point of view, nothing. If you made an additional repayment of $1,000 (creating a redraw of $1,000) you will save the exact same amount of interest as if you put $1,000 into an offset account.
The biggest difference between an offset account and a redraw facility is tax. If you pay down your home loan and one-day move houses and want to keep your house as an investment you could be disadvantaged by not having an offset account. This is because the loan on the now investment property is tax deductible so you want that loan to be as big as possible and your new home loan (that isn’t tax deductible) to be as small as possible and there’s no way to alter this once you pay down the loan.
An offset account is treated differently in this instance as you have the flexibility to take the funds out of your offset account on the now investment property (effectively increasing the loan, interest and tax deductions) and put these funds against your new home loan (or an offset account against it).
Assuming interest rates on the two loans is the same, the interest you pay is exactly the same however the split between what’s tax deductible and what’s not will be better and you will pay less tax.
An offset account sounds great however the cynic in me thinks the banks like them too as they could make borrowers spend more and keep loans higher for longer. Why would I think this when the interest paid is exactly the same? Humans aren’t always rational and although taking funds out of a redraw or an offset account achieve the same result the way some people think about this transaction could be very different.
There’s a thing called “the wealth effect” which essentially means that if you feel wealthier you’ll spend more. People who build up an asset/offset account may feel wealthier than if they had no offset account but had paid down their home loan and spend more than they otherwise would. Although exactly the same, some people don’t like to borrow to spend so there’s a mental barrier of redrawing vs spending the offset account. The fact either way, if you have any debt, every dollar you spend is a dollar borrowed as this spending could be put against your loan/into an offset account reducing the amount of interest you pay. This shouldn’t be an issue if you’re aware of this and if you’re particularly good with money or have a system such as keeping your offset account separate to your everyday transaction account.
Lastly, an offset account may be more expensive in the form of a higher interest rate or higher fees. There are plenty of good, cost-effective options available but you should consider the benefits to you if there’s an additional cost.