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Offset is how repayments, extra payments and other interest reducer features affect the interest calculation and overall cost of your mortgage. Contrary to popular belief, offset is not a feature, but a characteristic of a loan. Although offset is a little complex to understand, it is a crucial characteristic if you wish to accelerate your mortgage and repay in less time with less money.
Most mortgage lenders calculate interest on daily balances, but only charge it monthly. This means if you change the balance of your loan on any day by making an extra payment, the interest calculated for that day will be lower than the lender predicted when they estimated your minimum repayments. This reduction in the interest calculation is called 'offset' because the extra money has 'offset' the loan balance for the purpose of interest calculation. Most lenders, although not all will pass the savings from this interest reduction on to you.
Offset becomes relevant if your mortgage is an all in one or offers interest saving features such as accepting extra payments or other interest saving facilities such as 'offset accounts'. When used properly, these features will reduce the interest you will pay and the time it takes to repay your home loan.
How offset shortens your mortgage
Although offset will reduce the interest you pay on both principle and interest mortgages and interest only mortgages, offset will usually only shorten the length of your mortgage if you are already paying principle and interest. This is how it works.
When you take out a mortgage, your lender calculates a Minimum Repayment that you are required to make as a part of your loan contract. Your Minimum Repayments are based on four key variables.
- Loan Balance
- How often you will make repayments (also called repayment frequency)
- Interest rate
- Your specified loan term
Each of these factors is called an assumption as the lender assumes a value to enable them to calculate your Minimum Repayment. From these assumptions each Minimum Repayment has an assumed principle component and an assumed interest component. The interest component is based on your interest rate and assumed daily Loan Balances. So each Minimum Repayment will be made up of two parts and is best thought of as:
Minimum Repayment = Interest + Some Principle
Where Interest is the charge the lender makes for lending you the money and Some Principle is an amount of money that goes towards reducing the amount of money that you owe (your Loan Balance).
If your actual Loan Balance is less than the assumed Loan Balance when your Minimum Repayment was calculated, then the amount of interest due will also be less however your Minimum Repayment will remain the same. As a result, the part of the your Minimum Repayment that was assumed as, but not charged as Interest goes towards Some Principle and reduces your Loan Balance. This then creates a reduced Loan Balance for all subsequent Interest calculations and the savings begin to snowball. What starts out as a modest saving builds up speed an power over time.
Small, regular deposits can wipe years off your mortgage and save you tens of thousands in interest.
Offset - the nett of tax advantage
For personal borrowers, using your savings to offset the balances of your mortgage is far more effective than having those same funds deposited in even a high interest savings account. The reason for this is two fold.
The first and most obvious reason is the rate of interest you are charged on your mortgage is usually higher than the rate of interests earned from banks and other most 'safe and accessible' savings accounts. As an example, if the interest charged on your mortgage is say 9%, you will probably earn around 7% for funds in a high interest savings account. As a result, your gross advantage of having money offsetting your mortgage would be around 2% over interest earned from the savings account. ie. money offsetting your mortgage means you are not paying 9% rather than earning 7% from a high interest savings account.
The second, and sometimes less obvious benefit is that income earned is taxed, whereas expenses you avoid, are not. Most people, need to read that sentence twice, so here it is again. Income earned is taxed, whereas expenses you avoid, are not.
This means that if your savings earn interest of 7%, you will be required to pay tax on those savings. If your marginal tax rate is say 30%, you will be required to pay tax of 30% x 7%, or 2.1%. This means your nett of tax advantage for those invested savings is 7% - 2.1% or 4.9%.
Compare this to saving 9% in mortgage interest for having those funds in offset instead which results in you avoiding an expense of 9%. Your nett of tax advantage is 9% in offset versus earning 4.9% interest, which is a substantial difference.
However the nett of tax advantage only applies if the borrowings are for personal use. Investment borrowings do not get the same advantage because the interest on investment debt is tax deductible. So whilst you will get a slightly better return because you avoid paying a higher rate than you would otherwise earn, there is no real tax saving.
Partial Offset
Partial offset is an offset feature where only a portion of your extra funds offset interest calculation for that day. For example, a partial offset of 40% will only offset interest calculations by $4,000 when you have extra funds of $10,000 in your offset facility or mortgage. Although this type of feature is most common amongst fixed rate loans, some lenders sneak it into their variable rate loans as well. If you want to get the most from your offset facilities, make sure they are 100% offset, regardless of which type offset feature you choose.
Different types of offset features
Different mortgages have a range of features that are often clustered together by lenders as 'offset', however these features operate differently and can result in starkly different outcomes. If you are interested in interest offset options you should also read the offset account vs redraw vs all-in-one tutorial.
Extra payments and redraw
Available on most loans and commonly passed off by sneaky lenders as 'offset' to beef up the appeal of their 'cheap' mortgage. Money can be deposited into the loan from another account and when redrawn, must be transferred to another account to access those funds.Offset account
An offset account is an account that is separate to your mortgage that you can use for everyday banking like depositing your pay, growing your savings and paying your bills. Although the offset account is separate to your mortgage with separate statements, access and balances, the daily credit balance of the account offset the debit balance of your mortgage for the purpose of calculating interest.All-in-one
There are a couple of different types of all-in-one mortgages available, however the offset and access benefits are a combination of the extra payment/redraw feature and the offset account feature. Your every day banking is done directly from your home loan. Be careful of the 'cheap' version of these loans as lenders will promote the mortgage as 'fee free', but then charge you each time you access deposits. Small regular charges can really add up.Beware of
Mortgages that do not allow additional payments. If a mortgage does not allow additional payments, you will have no choice to pay it off over the full term. If mortgage allows extra repayments, check that offset applies and it commences on the day you make your extra payment.
You should also beware of Lenders who describe offset as a special feature of a mortgage as all good quality mortgages offset additional payments. The term 'offset' is often used by lenders to describe different mortgage features in an attempt to make inferior products sound better and the benefits and disadvantages are fully explained in the features section mortgage tutorials which you can find here.
