Future Focus: The tax-free returns Aussies are taking advantage of
There are smart ways to take advantage of your offset account, but balance is the key.
For many Australians, the offset account feels like a financial safety net. It’s a tool where money works quietly in the background reducing your mortgage duration and saving interest. It’s also tax effective.
It is easy to justify putting your excess cash into an offset account without thinking about it too much. Good intentions may get in the way of achieving your financial goals.
There are suggestions that people may be overusing offset accounts. Balances in offset accounts have increased to 11% of the credit limits. This is the highest amount since APRA started collecting this data. Many of us are sitting on growing offset balances. All it takes is a bit of work to figure out if this is the right strategy for you.
What does an offset account do?
An offset account is linked to your home loan. The amount that sits in your offset account reduces the loan balance. Since interest is accrued on the outstanding loan balances this reduces the amount of interest you pay. Above I quoted the APRA data that showed balances had increased to 11% of credit limits. In real terms, this means that homeowners with mortgages are paying interest on 89% of their total remaining mortgage balance. If the loan is $1,000,000, the average Aussie would have $110,000 in the offset. Interest would be calculated on an $890,000 balance.
The first step of assessing the best option for any extra funds is to quantify the impact of additional contributions to an offset account. Make sure to take a total return view by including all fees, taxes and costs. A powerful benefit of an offset is the return is already net of fees, costs and taxes. This makes for an easy calculation. My interest rate on my home loan is 5.14%. That means that if I have $100,000 in my offset, I’m saving $5,140 a year.
This is equivalent to a 5.14% after-tax return on cash – a ‘safe’ asset. To garner the same after-tax return outside of the offset account, you need to earn a 7.34% return (30% marginal tax rate) on a cash investment. Not easy.
As attractive as this sounds, the decision to utilise your offset is far more nuanced. The account offers flexibility, liquidity and strong tax-free returns. That doesn’t mean additional contributions fit your investment strategy.
Is 11% too much?
It is difficult for me psychologically to carry debt. Even if it is classified as ‘good’ debt. When I have spare cash my instincts are to put it in my offset account. It not only feels like you are reducing a mammoth loan and getting closer to paying it off, but also acts as a buffer for the unexpected.
This can come in handy when owning a property. They come with unexpected costs. The roof may need to be replaced (happened to me). The floor might need to be repaired (happened to me). There may be a water leak that damages the walls, and they will need to be repaired and replastered (happened to me). Not bad considering I bought my house a little over two years ago.
These are all costly endeavours that require a cash outlay. It feels good to have it sitting there.
It also guards against unexpected life circumstances. You may lose your job and it can help you meet your mortgage and living expenses.
The issue with continuing to build your offset means you may not consider the opportunity cost of having the cash sit there. You are increasing the portion of your net worth that is in cash – a non-performing asset. You may reduce interest but it’s not growing in your offset. Over time, inflation is quietly eroding the purchasing power of the cash.
So while you may be saving interest, you’re also missing out on compounding investment returns that could get you to your other financial goals faster. I think this is an important point to consider. As much as holding debt gives me anxiety it would be far worse if I derailed my chance to achieve my financial goals.
For example, say your loan amount if $1 million, and you have a $300,000 offset balance. Your loan interest is 5%. You’re saving $15,000 a year or $150,000 over ten years through the funds in your offset.
If your emergency fund needs are $100,000 that leaves $200,000 in excess funds. If you invest the money instead of keeping it in an offset account and earn a 6% annual return, the investment would grow to $358,000. Tax would be owed based on the types of assets, but it is still a large difference.
Prevailing interest rates are a large factor in the decision with the attractiveness of an offset dropping in low-interest rate environments. Offsets become more attractive for those on higher marginal tax rates.
My colleague Mark LaMonica has written about hurdle rates here.
There is no guaranteed return in markets like an offset account. The trade-off between a sure thing and the potential for a better outcome makes it a difficult choice for investors. It is worth understanding all of your financial goals, and how it fits with your mortgage.
The reality of a mortgage is that it is usually a large loan and paying it off takes decades. What helps me is looking at an amortisation schedule as a reminder of how mortgages work. It provides comfort, especially at the beginning of the loan, that we are making progress. The loan amount at the beginning of the loan can often mask this. My husband and I have other financial goals that we want to achieve which means we need to save and invest for them concurrently.
It’s important for us to have experiences at every stage of our lives. We want to enjoy and take part in activities and travel while we are younger. Without oversimplifying it, it is all about balance and understanding not just your end goals but the pathways to get there. It is about understanding the actions you’re taking and why, so you can maximise your quality of life and your outcomes.
The approach isn’t revolutionary in any way. The offset is a fantastic tool that can be used as appropriate as part of your overall investment strategy.
Finding your ‘ideal’ offset balance
Your ‘ideal’ offset balance will depend on life stage, cashflow, employment status and interest rates. The below framework will help you understand the baseline amount.
- Emergency fund: 3-6 months of expenses for salaried individuals, 1 year for self-employed.
This amount covers job loss, medical emergencies or unexpected repairs.
- Upcoming short-term goals (next 12-24 months)
This could be an overseas holiday, maternity leave or renovation. Investments in equity markets that typically offer higher returns may be too volatile for this short time period. Putting it in the offset will reduce your interest expenses in that period while maintaining liquidity.
- Every day cash flow cushion
I use my offset account for lumpy costs that I know are incurred annually or every few years. This includes home insurance, council rates, land tax and health insurance. It can reduce interest while providing a place to save for these lumpy costs.
Every dollar above this should be carefully considered. Depending on your hurdle rate, it could be better placed in other assets to grow your wealth.
Final thoughts
Your offset account is one of the most flexible and tax efficient products at your disposal. Using it efficiently can shave years off your mortgage and give you peace of mind.
However, that doesn’t mean it is the best way to build wealth and achieve your financial goals.
Once you’ve covered your immediate needs understand where the rest of your funds are best placed in relation to your financial goals. Investing may be the best choice to help your funds grow and compound as you concurrently pay off your loan.
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