A frequent question we receive when discussing residential home loan options with clients is, ‘should I choose an offset account or redraw facility for my loan?’
And there’s a good reason for this: structuring your loan in the most efficient way for your needs is important not just for servicing the loan while you live in the home, but also to lay the foundations for future financial success.
What’s the difference between offset and redraw?
Let’s rewind for a moment and look at what these options actually entail.
An offset account is a savings or transaction account opened with your lender which is linked to your home loan account. As funds are deposited into the offset account, the balance is ‘offset’ daily against the home loan balance. The interest you pay on your loan is then based on the difference between your loan amount and the offset account balance.
In short, the more you have in your offset account, the less interest you pay on your loan. This means more money goes to paying off the principal of your loan each month, rather than interest. Offset accounts are available for owner-occupied and investment home loans, but generally only on variable rate loans.
Generally, when a loan contains a redraw facility, the lender sets a minimum regular payment amount - for example, a monthly figure that covers the principal & interest and any fees on the loan. Then, any payments you make above this minimum amount will accrue and you can later redraw these funds if needed. There may be additional conditions to meet, such as getting approval from your lender to redraw and transaction costs to redraw the funds.
Offset vs redraw: Pros and cons
There are many reasons you may choose a redraw facility or offset account for your loan, but some of the most common benefits and disadvantages are listed below.
Can assist in paying off your loan faster by reducing interest payments and directing more funds to the principal
Simple, easy to understand and user-friendly
Not classified as income
May incur an additional fee, such as an annual home loan package fee
Interest rates may be higher
Typically a minimum monthly payment is still required
No additional fees and easy access to your own funds - however this may bring temptation to spend rather than save or pay off the loan!
Additional payments reduce the principal owing on the loan, reducing the overall amount and therefore the interest you are charged
Flexibility to make additional payments while retaining access to your savings in case you need it down the track
Generally no fee for the redraw facility, but transactional fees to make a redraw may apply
Redraws may be subject to minimum amounts or caps
Less control over your funds due to additional protections and conditions
Potential tax implications depending on how you use redrawn funds
Your property plans: choosing the right loan structure for you
Considering which loan structure allows you to most efficiently pay off the loan is of course a crucial step in securing home finance. However, for many BFD Finance clients there are other considerations that are very important to ensure the loan is suitable not just now, but well into the future.
The main question to ask yourself is: ‘will this property be my forever home?’
Why does this matter? So you can retain flexibility in the future.
When securing finance for a property that you intend to make your home (or Principal Place of Residence), then the first instinct is to think, ‘how can I pay this off as quickly as possible?’ This is a great approach if you plan to live in the property forever, but if you plan to buy a new home in future years and potentially retain the first property as an investment, you need to consider the future tax deductibility implications of your loan structure.
If you’re buying your forever home, a redraw facility can be a great option to keep contributing funds to the principal of the loan and reduce the amount on which you’ll be charged interest. At the same time, you have the flexibility to redraw funds to meet the changing demands of life.
If the intention is to eventually convert the property to an investment property in the future, an offset account may provide greater flexibility. The reason for this is related to tax deductibility: the interest you pay on an investment loan is tax deductible, because it is a cost incurred in the course of producing income.
With an offset account, you can move funds in and out of your offset (increasing or decreasing the amount of interest charged), but the loan amount remains the same and continues to be income-producing, so the interest is generally tax deductible. Because of this, it doesn’t matter if the money in your offset account is used for income-producing purposes or not: the purpose of the original loan is what determines the tax deductibility of the interest.
Conversely, if your investment property loan includes a redraw facility and you redraw funds for a purpose that is not income-producing, then the loan amount itself has changed and it now has a mixed purpose: some income-producing (your investment property) and some non-income-producing (the redrawn funds used for other reasons). That means that any additional interest you pay on the loan, proportionate to the additional redrawn funds, is not tax deductible.
Essentially, this means you may have less flexibility in accessing your savings down the track if you secure a loan with a redraw facility and retain that property as an investment.
Let’s look at an example to demonstrate.
Jane purchased her first home in 2016 for $1.0m with a loan of $800,000. The current balance is now $600,000 with a redraw facility of $150,000.
Jane is looking to purchase a new home and wants to keep the current property as an investment. She decides to redraw the full $150,000 amount for the deposit and purchase costs on her new property.
This means her loan balance increases to $750,000 and now has a mixed purpose with regards to income production. This means that not all the interest she pays on the loan is tax deductible. The original $600,000 relates to the first property, which is now an investment. The additional $150,000 is not income-producing as it relates to the purchase of Jane’s new home. $600,000 is 80 percent of $750,000, so therefore only 80 percent of the interest Jane pays on the loan should be tax deductible.
The moral of the story is: when determining the best loan structure for your property, think about the purpose this property will have not just now, but in the future. If property investment is an important part of your financial plan, considering the tax implications of a redraw facility compared to an offset account now may save many headaches in the future.
If you’re looking for more guidance on the best way to structure your home loan, reach out to the expert BFD Finance team today.