On one hand, paying off a mortgage is a massive achievement, one that should be celebrated and can bring valuable peace of mind. On the other, keeping money in an offset account reduces the interest paid on a home loan and still allows a borrower access to a large chunk of cash if the need arises.
Both options have a strong case, each with notable benefits and drawbacks.
So, if you’ve found yourself with a lump sum of cash, InfoChoice has compiled all you need to consider when contemplating whether to pay down your home loan’s principal balance or to store the cash in an offset account.
Important to note, however, that neither making a substantial lump sum nor keeping money in an offset account will reduce a person’s regular repayments. That is, unless the mortgage is paid off entirely, in which case repayments will cease, or a borrower refinances their home loan.
Rather, both options will reduce how much of each repayment goes towards interest and increase the amount that goes towards the principal balance. For that reason, each option will likely lower the time it takes to repay a home loan and save on interest costs into the future.
See Also: Extra Repayment Calculator
See Also: Lump Sum Calculator
Argument A: Keep excess funds in an offset account
If you hold an offset account in which you store spare cash, you’re far from alone. Australian borrowers kept more than $255 billion in offset accounts in the September quarter, according to Australian Prudential Regulation Authority (APRA) data.
“The biggest benefit of an offset account is that it allows you to save on the interest expense of your home loan repayments,” Icon Mortgages managing director Jasjeet Makkar told InfoChoice Group.
Another benefit of utilising an offset account is ease of access. Offset accounts can typically be used just like transaction accounts. That means you’ll probably be given a debit card attached to the account and, therefore, can incorporate the account into your day-to-day banking and spending habits.
Of course, good things rarely come for nothing.
“One of the major drawbacks is offset accounts aren't free, lenders will generally charge a homeowner a fee to have an offset account,” Mr Makkar said.
Additionally, many of the market’s most competitive home loan interest rates aren’t available on mortgages with offset accounts. Some lenders even offer lines of entirely different home loan products: Mortgages with offset accounts and mortgages without offset accounts. The former typically incurs a higher rate or an extra monthly fee.
In this case you will want the interest saved to outweigh the extra costs or the heightened the home loan interest rate.
Let’s take a fictional Aussie and their imagined home loan as an example.
Kate bought a $340,000 unit with a $40,000 deposit in 2023, signing up to a home loan with a 6.00% p.a. interest rate – the average for a new home loan, as per Reserve Bank of Australia data considering October 2023.
Thus, Kate has a $300,000, 30 year home loan. She also recently sold her car and pocketed $50,000 of cash for doing so.
She decided to keep that cash in an offset account. That means Kate will only pay interest on $250,000 ($300,000 - $50,000).
By keeping the $50,000 in her offset account, and assuming she never grows that balance and that her interest rate stays the same over the years, she could wipe 10 years off her mortgage’s life and save $168,500 in interest.
Such an outcome is no doubt appealing to many borrowers.
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Argument B: Use excess funds to pay down a home loan’s balance
Meanwhile, using excess funds to pay down a mortgage’s principal balance might seem equally or more attractive. Particularly if you have a lump sum that’s equal to the amount you’ve borrowed on your home loan.
“Additional loan repayments are a great tool to get debt free as quickly as possible,” Mr Makkar said.
The major benefit in paying off your home loan entirely is your regular repayments coming to an end.
Another benefit is the peace of mind bought by being mortgage free. Not having a mortgage would likely mean you would be the sole owner of your house. That’s the ‘Australian dream’ after all.
However, if your nest egg isn’t quite large enough to pay down your home loan’s entire principal balance, making a lump sum repayment could still be worthwhile.
One consideration is that once you’ve made that payment, it likely won’t be available again, unless it was made into a redraw facility.
While using a redraw facility isn’t always as easy as accessing funds in an offset account, it can generally be done relatively quickly online. Though, some lenders might limit how much can be redrawn at a time or within a set period, or charge a fee for redraw transactions.
In addition, a redraw still sits within the loan facility and isn’t separate like an offset account. Lenders usually limit the facility to less than the loan balance.
Additionally, when a home loan is paid off, funds once accessible through a redraw facility will be locked up in a home’s equity.
Kate is back and, this time, she’s decided to make a lump sum repayment to the value of her $50,000 nest egg.
Now, paying an extra $50,000 off her relatively new mortgage would provide pretty much the same benefit as would putting her extra cash in an offset account.
Of course, it might have been a different story if she found herself with a $300,000 windfall, as using it to pay off her principal balance entirely would see her close her mortgage facility.
Tax time: When keeping a home loan can be beneficial
There are some instances that keeping a hold of a home loan can be beneficial. Perhaps the most widely known instance is if a person plans to use their property as an investment and will yield rental income.
That’s due to the potential for negative gearing. Negative gearing is a method in which a property investor can reduce their taxable income if they spend more money on their investment than they earn in rental income in a given year.
Home loan interest is considered an expense incurred by a property investor. Thus, in the right situation, having a home loan that is earning interest can help to minimise a person’s tax obligations as you can offset the interest paid against your taxable income.
However, it's worth remembering that to utilise negative gearing, an investor must be losing money on their investment. Thus, engaging in negative gearing may not be sustainable over the long term.
Concerned about liquidity? Offsetting might be for you
Of course, the major drawback of paying off a home loan is the resulting loss in liquidity.
Liquidity refers to the ease in which a person or business can turn assets into cash. The faster one would be able to turn their asset (say, a house or shares) into cash, the more liquid that asset and their finances are said to be.
High liquidity could be a blessing if an unexpected, hefty bill were to land on a person’s desk, or if they decided to make an expensive purchase for which they needed cash.
Bricks and mortar are famously illiquid.
To draw cash from stone one typically needs to engage a real estate agent, find a buyer, go through a negotiations process, meet any conditions of sale (including finance of the purchase), and then wait for settlement.
When there’s an active home loan in play, however, a homeowner can simply redraw their extra repayments or refinance their property to meet their financial needs. It’s a far more liquid process.
Further, the interest rates typically offered on home loans are generally among the lowest available on any finance product. Not to mention, home loans often allow access to far greater sums of money – sometimes even millions – due to the costly nature of Australian housing. Comparatively, most personal loans or car loans might only provide a borrower up to $100,000.
Worthy of consideration, however, is the lengthy nature of a mortgage. Repaying a lower-interest debt over a few long decades could end up costing a borrower more than would repaying a higher-interest debt over a few short years.
Savings account versus offset account
The short answer is: Probably not.
As they say, a penny saved is a penny earned, and money saved on home loan interest could be worth more than the yield on a deposit product.
That’s because savings account and term deposit interest rates are generally lower than those of home loans. Thus, the interest gained from a savings account or term deposit likely won’t outweigh the interest that would have otherwise been saved from reducing the principal balance of a home loan.
In addition, interest earned from a savings account or term deposit is considered taxable income, while interest saved isn’t.
However, if your offset account has a balance that’s greater than that of your home loan, it won’t provide you any benefit. That could be considered an opportunity cost.
Thus, if you have a $200,000 mortgage and $220,000 in an offset account, the additional $20,000 could be better kept in a savings account or term deposit, even though the resulting interest will be taxable.
Not to mention, the Financial Claims Scheme will only guarantee $250,000 of an individual’s money held by a bank in the event the institution collapses. If you’re storing more than $250,000 in an offset account and you’re anxious about your bank collapsing, it could be worth making a lump sum repayment or moving funds over the $250,000 mark to another bank.
What if you have a fixed rate home loan?
This whole conversation gets a little more complicated if a fixed rate home loan is involved.
That’s largely due to the fact that many fixed rate home loan products don’t offer offset accounts and will generally demand borrowers pay a break fee if they make extra repayments that rise above a set threshold.
On top of that, and in relation to the above discussion on savings account and term deposits, it might be worth considering if your fixed rate is lower than the yield on a deposit product would be.
The RBA embarked on its fastest hiking spree on record in mid-2022. If you fixed before then, you might still be realising an interest rate of around 3% (maybe even less).
In that case, the current rates offered by savings accounts and term deposit products might well outweigh your home loan interest rate - at least until your fixed rate period ends.
Still, it could be worth talking to your lender to see how much you might owe in fees if you were to make a lump sum repayment during your fixed rate period.
As individual situations will vary greatly, reaching out for professional independent financial advice could prove invaluable.
Can your lender demand you repay your home loan?
If you’ve decided an offset account is the right solution for you, you might also be wondering what your lender would do if you put the entire value of your home loan’s principal balance in the offset account. After all, doing so would deprive them of nearly all the interest that would otherwise accrue on your mortgage.
Well, ultimately they can’t do anything.
The money you keep in an offset account is your money, just like the money kept in a savings account is your money.
Under regular circumstances, a bank or lender can’t demand you pay off your home loan, whether you have the means to or not.
However, it is worth noting that some non-bank lenders – which by law cannot take deposits – offer products that might appear to be offset accounts but are in actuality redraw facilities. If the balance of such a facility outweighs the principal balance of a home loan, the loan facility will likely be closed.
It could be worth a borrower taking a close look at the terms and conditions of their home loan and offset facility before loading it up with all their spare cash.
Offset account vs extra repayments: Pros & cons
Keeping excess funds in an offset account
Funds kept in an offset account are offset against home loan balance, thereby saving interest
It's generally easier to access funds in an offset account than those used to pay down a home loan through a redraw facility
As home loan interest rates are typically higher than savings account interest rates, keeping funds in an offset account could provide greater benefits than keeping them in another deposit product
Lenders generally charge fees or provide higher interest rates to those who have an optional offset account
Only $250,000 of an individual's funds deposited with any single institution is covered by the Financial Claims Scheme in the case of a bank’s collapse
Home loan repayments will continue, even if the balance of the offset account outweighs the mortgage’s principal balance
Paying off a home loan
If a mortgage is paid off, a homeowner will no longer need to make regular repayments
By paying off a home loan entirely, a borrower can officially own their own home, which can provide peace of mind
By closing a home loan facility, a borrower loses access to the equity held within the property which could impact their liquidity
Property investors without a home loan can’t claim interest costs as a tax deduction when negative gearing
If a home loan facility is paid back entirely, a person will no longer be able to redraw the funds used to repay it
Image by Joshua Hibbert on Unsplash.