Hi
I am crunching some numbers in considering getting a home loan with either Offset / Redraw only facility.
REDRAW
I know that when I enter into a loan, the loan balance will be calculated. Any additional payment will only reduce the home loan balance (not the principal). For example:Principal: $100,000
Interest Rate: 5.5%
Term: 20 year / 240 months
Total Interest Payable: $64,405
Home Loan Balance at month 0: $164,405.00 ($100,000 + $64,405)If I make an additional payment, it will simply reduce the ” $164,405.00 ” balance.
While this allows me to pay off my loan faster, the money would actually be better off sitting in a high-yield saving account.OFFSET
However, what I do not know is how the offset account work.
I can only assume either of the following:1. Interest earned in your offset account is offset against the interest calculated. For example, at the end of month 1:
Principal Owing: $100,000
Loan Term: 360 months
Home Loan Rate: 5.5%
Interest Payable: $447.17Amount in Offset: $5,000
Offset Savings Interest Rate: 5.0%
Interest Earned on Offset: $20.37Therefore I would need to pay the interest of $426.8 ($447.17 – $20.37).
– OR –
2. The interest is calculated by offsetting the principal owing. For example, at the end of month 1:
Principal Owing: $100,000
Loan Term: 360 months
Home Loan Rate: 5.5%Amount in Offset: $5,000
Interest is calculated based on: $95,000 ($100,000 – $5,000)
Interest Payable: $424.84Therefore I would need to pay the interest of $424.87.
While the difference of almost $2.00 per month is not much, this number will increase significantly when the Principal, the amount in offset, and the interest rate changes.
I know that many places have been saying it is method #2, but none seems to mentioned the actual saving (e.g. the reduction of interest payable, the total payment made etc). Therefore I am a bit caution in taking on the advice
Could anyone confirm which method is the offset using ?
Thanks
It is the latter – funds which sit in your offset account equate to having a reduced outstanding loan principal. The reason that lenders do not quote how much you save in interest is that the amount varies greatly within the month ie between payday and taking out/paying for expenses.
Thanks Scott.
That sounds really wonderful.
So if the offset really offsets the principal (method #2),can you actually see from your statement that the interest payable for a particular month is significantly lower ?
Hi Zack,
The simple answer is it depending on the purpose of your loan and loan intentions.
1) Owner Occupied (OO) debt vs Investment (INV)
I would recommended redraw for OO and generally offset for INV. Definitely not redraw for INV as this can cause issues with taxation, however please consult your tax agent with respect to this.
Redraw allows you draw back the extra amortised principle you have paid, especially, if you have keep your payments higher as interest rates have reduced. The issues which arises is if you draw back addition principle from an INV loan then it need to be used for investment, otherwise you will limit the loan’s tax deductibility. But generally, an investor wants to maximise their interest charges for tax deductibility reasons, hence even an offset account may not be best.
2) Access features
Some Offset account will allow you unlimited (or near) transactions action so it can possible replace you bank account, hence avoiding saving account fees. Some Offset account provide high fees structure or and may not provide 100% offset. These are great for INV loans as the “redraw” from the offset can be used for anything, hence there is no suggestion to be used as for investment only.3) Principle reduction
Interest is calculated daily and charged monthly. Therefore, keeping the principle down will enable each repayment to be more and more affective and reduce your overall loan faster. The saving will be time and this can save you thousands in interest.^ Thanks for your reply.
I am looking to buy a house as OO.
From what I understand (I could be wrong here), the way redraw feature works is that it allows you to redraw the extra amount of repayment you made every month (the amount above your minimum monthly repayment). These extra repayments are used to reduce the interest portion of your loan first. It will only reduce the principle portion once the interest portion have been fully paid up.
However, from what you mentioned above, it seems you're saying that whatever extra repayment will immediately be used to reduce the principle. Correct me if I'm wrong here.
So…….. could you let me know which exactly is the correct way of how a redraw feature works?
Also, in what circumstances is an offset account not as good as redraw for an OO loan?
Thanks!(Lets assume that there is no fee on the redraw & offset facility, no minimum withdraw / deposit, interest rate on the loan without offset is the same as interest rate on the loan with offset, same fee structure on both types of loan, and the offset offers a 100% offset.)
I agree with Iblinks but would personally on use Interest only with an offset for owner occupied loans too. The main reason is it keeps the loan amount high while saving you the same interest. If you ever move out of the house and rent it you will have much more tax benefits. Also if things become tight you can have lower monthly repayments to help you get through it.
Terryw | Structuring Lawyers Pty Ltd / Loan Structuring Pty Ltd
http://www.Structuring.com.au
Email MeLawyer, Mortgage Broker and Tax Advisor (Sydney based but advising Aust wide) http://www.Structuring.com.au
Hi Zack,
How a redraw feature generally works is as it is different for Principle & Interest (P&I) loans as to Interest Only (IO). This is because the lending institution only allows you to redraw back to the limit where the loan should be at that time.
Example;
Let say loan is $400,000 (IO) for 5 years and you make extra payments of $1000 per month. Then for the first 5 year you redraw exactly how much extra you have put in.
But now let’s say the same loan is PI for 30 years and you make still extra repayments of $1000 per month. So this means you have put in an extra $12,000 by the end of the year. Let’s say by the 1st year mark of the 30 year loan the bank expected you to be at the principle limit of $396,000 because your minimum monthly payment is interest a bit of principle then in theory you could only redraw back to $396,000 this is so you stick to the original contract terms and pay the loan off in 30 years. This means you would only be able to access $8,000 redraw after 1 year. Advantage is only one account is need the home loan account.
There are different offset accounts too. Some are 100% offset but own if you retain above say $1000 in the offset account. Some offsets are interest earned (hence tax is payable on the earning). Offset is an another account, banks have a track history of introducing fees. They can also attract higher transactional fees, hence you lose the any interest benefits. They may also say unless you credit over $2000 per month you’ll have no offset, meaning they want you to use it a s a transaction account. I always ask why in these situations.
If your purpose is to reduce yo debt and pay it off, I would rather get into the mental frame of mind and reduce the principle, hence no errors can made in calculating the interest, as how much is offset?
The rule with interest is it is calculated daily and accumulates and is charged monthly (I have seen some banks actually charge it fortnightly) to match your repayment cycle, this keeps your principle balance higher hence more interest is charged. This is criminal.
With a redraw it can immediately reduce the the principle owned and hence reduces the level of interest you pay. Like a credit card, they can charge you 14%, but you don’t care if you have no outstanding balance or debt owed. If there is no principle owed then there are no interest charges. With my clients I like to align them with the right product to fit their purpose. I wouldn’t worry what someone else has all we need to do is fit the right product to what you would like to achieve long term.
I trust this assist you.
Terry's right.
Thanks!
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