Most modern home loans come with a redraw facility and/or a mortgage offset account so you might be wondering what the difference is and which is the most tax effective mortgage type.
With a redraw facility you can make additional payments to reduce the outstanding balance of your mortgage, which in turn reduces the amount of interest you pay. However, those additional repayments are not locked away – you can redraw on them at some point in the future. This increases the loan balance, so you’ll pay more interest.
An offset account works more like your day-to-day bank account. However the balance of the offset account is subtracted from the outstanding balance of your mortgage, and you only pay interest on this difference.
So which is the better way to manage your mortgage and minimise interest payments: redraw or offset?
For many homeowners it won’t make much difference. The offset account is a bit more convenient as all your cash is working to reduce the outstanding loan amount on which interest is calculated. The redraw facility may require a bit more active decision making regarding how much to pay off or redraw and when. Some banks also set minimum redraw amounts or may charge fees on each withdrawal. On the plus side, the extra effort involved with a redraw facility can provide an element of discipline for people tempted to dip a bit too readily into the available funds in the offset account.
If you are borrowing to invest, however, choosing between redraw and offset can have a significant impact on your tax bill.
Imagine you buy an investment property and have a loan of $500,000. The interest on this loan is tax deductible. You then receive a windfall that allows you to pay off $100,000, leaving a loan balance of $400,000. Soon afterwards you redraw $50,000 to splurge on an overseas holiday. The loan jumps to $450,000, but as the redraw is for personal use the loan amount attributable to the investment property remains at $400,000. You won’t be able to claim a tax deduction for the interest on the $50,000 redraw. What you will likely end up with is a headache from trying to manage the personal and investment components of the loan as future repayments or redraws are made.
Now imagine that you deposited your extra $100,000 into your offset account. The bank subtracts this from your loan balance of $500,000 and only charges you interest on the $400,000 difference. The crucial difference is the loan amount is still $500,000 and all attributable to the investment property. The withdrawal of $50,000 from your offset account is unrelated to the investment arrangement. Yes, you’ll pay interest on the full loan amount of $450,000, but it will remain fully tax-deductible.
Even if you are not a current investor but there’s a chance your existing home may turn into a future investment property, the same principle applies. This is where it could get very tricky.
Provided you have the discipline to manage your offset account, it can provide more flexibility than the redraw facility and could save you costly tax issues. To be certain about what suits you best, always seek professional advice.