Offset accounts are one of the most popular financial tools for Aussie mortgage holders, but are we relying on them too much?

In this episode, Mark and Shani break down how offset accounts work, why balances are now at record highs, and the hidden opportunity cost of keeping too much cash in them instead of investing.

Using real examples, Shani’s own mortgage journey, and clear maths, they explain how to decide your ideal offset amount, how to calculate your personal hurdle rate, and how to balance your mortgage with your wider financial goals.

You can find the full article here.

You can also find another article from Shani about the main decisions that mortgage holders have to make to optimise their situation.

You can find the transcript for the episode below:

LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Jayamanne: So Mark, you always make fun of me because I’m really scared of birds. But...

LaMonica: I mean, that’s true. I can’t really dispute that.

Jayamanne: No. But you are actually scared of an animal as well.

LaMonica: I don’t know if scared is the right word.

Jayamanne: Do you want to tell your story about when you were in Miami?

LaMonica: The backstory is Shani and I got a drink last night and I told her the story, and she was like rolling around the floor laughing at me. I was in Miami and I was going into the ocean and hanging out in the ocean. And then this enormous school of fish came and they were like, big fish. For those watching the video, I’m holding my hands on, but like, big fish, they could have been piranhas.

Jayamanne: They could have been piranhas.

LaMonica: They could have been.

Jayamanne: Are they common on beaches in Miami?

LaMonica: I mean, I don’t think so, but you never know. Like they...

Jayamanne: The ocean’s all connected, right?

LaMonica: They are. Yeah. I mean, I think they live in rivers in South America. Maybe they came up to Miami for the weekend. But anyway, they positioned themselves. They’re smart too. They positioned themselves. I wasn’t that deep. Maybe it was like chest high water. They positioned themselves in between me and the shore. And so it was difficult to know what to do.

Jayamanne: So what were your options?

LaMonica: I mean, one was Cuba, 90 miles away. I got to swim there. I guess I could have tried to attack them or something. I don’t know how you attack a giant school of fish. There were like thousands of them.

Jayamanne: I’m sure there were.

LaMonica: So yeah, no, it was pretty scary. So I waited. And I think because I froze in fear, they must not have known that I was prey. And they eventually swam off. And I went back to the beach and didn’t get in the water again and just ordered margaritas.

Jayamanne: That sounds like a good outcome for everybody.

LaMonica: Exactly. The fish are alive. I got margaritas.

Jayamanne: Yeah.

LaMonica: A good story. I don’t think it’s that good, but you really liked it yesterday. So what are we talking about other than my fear of aquatic animals?

Jayamanne: Well, today’s episode really only speaks to those who own property or are planning to own property.

LaMonica: So should I just get out of here?

Jayamanne: Yeah.

LaMonica: So we’re going to talk about, and this is based on an article you wrote, we’re going to talk about offset accounts.

Jayamanne: And for many Aussies, the offset account feels like a financial safety net. It’s used by a lot of us who do have a mortgage as a tool that works quietly in the background and it reduces your mortgage duration and saves you interest.

LaMonica: Yeah. And it’s tax effective and Shani loves taxes. So that makes it all the more attractive.

Jayamanne: So it’s easy to justify putting your excess cash into an offset account and calling it a day. But good intentions might get in the way of you achieving your financial goals.

LaMonica: And there’s been some data that you point to in your article that’s suggesting that perhaps people are overusing their offset accounts. So balances in offset accounts have increased to 11% of credit limits. And we’ll explain what this means in a second, but that is the highest amount since APRA started collecting the data. So many Australians are sitting on growing offset balances, but we want to talk in this episode about whether this is the right strategy. And if it isn’t, of course, what you should do instead.

Jayamanne: So first, why don’t we start off with the basics to build a foundation? So what does an offset account actually do, Mark?

LaMonica: An offset account is linked to your home loan. So the amount that sits in your offset account reduces the loan balance. And since interest is accrued on the outstanding loan balances, it reduces the amount of interest you pay.

Jayamanne: And just a moment ago, we quoted the APRA data that shows balances have increased to 11% of credit limits. So in real terms, this means that homeowners with mortgages are paying interest on 89% of their total remaining mortgage balance. And if the loan is $1 million, the average Aussie would have $110,000 in their offset. And interest would be calculated on an $890,000 balance instead of a $1 million balance.

LaMonica: The first step of assessing the best option for any extra funds you may have is to quantify the impact of the additional contributions that a lot of people are making to their offset account. So to do this, we need to make sure to take a total return view. So that means we need to include any fees, taxes, and other costs associated with any of these different options.

Jayamanne: And one of the biggest benefits of an offset is the return. Is the return is already net of fees, costs, and taxes. So it makes it a very easy calculation. So all you need to know is your interest rate. So my interest rate on my home loan is 5.14%. So that means if I have $100,000 in my offset, I’m saving $5,140 a year.

LaMonica: And this is not complicated math, but that’s equivalent to a 5.14% after tax return on cash, which of course cash is considered a safe asset. So if you’re looking for the equivalent outside of an offset to garner that same after tax return on a safe asset cash, you would need to earn a 7.34% return. So that’s assuming you’re in a 30% marginal tax rate. And I don’t know where you do your banking, but...

Jayamanne: They’re not giving you 7.34%.

LaMonica: Exactly.

Jayamanne: So as attractive as an offset sounds, the decision to utilize it is more nuanced than just putting in as much money as possible. And we’re acknowledging that the account offers flexibility, liquidity, and strong tax-free returns, but that doesn’t mean additional contributions fit your investment strategy.

LaMonica: Well, Shani, you are the one between the two of us that has a mortgage. So what do you think about this 11% offset balance that we talked about? Is that too much? Is it too little?

Jayamanne: Yeah, look, I’ve mentioned this before, but it is difficult for me to psychologically 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’re reducing a mammoth loan and getting closer to paying it off, but also acts as a buffer for the unexpected. And that really comes in handy when you own a property. They come with unexpected costs. The roof may need to be replaced, and that happened to me. The floor might need to get repaired, and that happened to me. And there might be a water leak that damages the walls, and they will need to be repaired and replastered, and that happened to me.

LaMonica: I mean, that’s bad luck. So the roof, the floor, and the walls, it’s almost like...

Jayamanne: It’s cooked.

LaMonica: It’s pretty much the whole house. I don’t know what’s left after that.

Jayamanne: I had a couple of comprehensive building reports as well.

LaMonica: And you’ve owned your home for two years.

Jayamanne: Yes. But it’s a very old house, and it does sound worse than it is.

LaMonica: It sounds very old. I mean, I’ve been to your house. I know how old it is.

Jayamanne: The costs were semi-expected. Our house was built in 1899, and a lot of this was discovered during renovation. So we did have a buffer. But houses do come with unexpected costs that are costly and require a cash outlay. So it does offer a lot of psychological and financial security to have it sitting there.

LaMonica: And as Shani went through, of course, cash does guard against those unexpected life circumstances. You could lose your job, especially if you’re me. And of course, then that cash can be used to help with your mortgage and other living expenses. But the issue with continuing to build and put cash into your offset means that you’re not thinking about the opportunity cost of having that cash sitting there. You are increasing the portion of your net worth that is in cash. Cash is a non-performing asset. So even though you are reducing interest, it’s not growing in your offset at all. So over time, inflation is quietly eroding the purchasing power of the cash that you have in there.

Jayamanne: So while you might be saving interest, you’re also missing out on compounding investment returns that could get you to other financial goals faster. And I think this is an important point to consider. So as much as holding debt gives me anxiety, it would be far worse if I derailed my chance to achieve my financial goals. So for example, say your loan amount is $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 10 years through the funds in your offset. If your emergency fund needs are $100,000 and that leaves $200,000 in excess funds, if you invest the money instead of keeping it in the offset account and earn a 6% annual return, the investment would grow to $358,000. Tax would be owed obviously based on the type of assets, but it is still a large difference.

LaMonica: And one thing to consider, of course, is the interest rate environment that you’re in. So the attractiveness of an offset drops in low interest rate environments. So remember, you’re saving on that interest on your outstanding balance. If that interest rate is lower, your savings are less. And obviously on the tax side of things, offsets become more attractive if you are in a higher marginal tax rate.

Jayamanne: And there’s one number here that can help you make a decision and that is a hurdle rate. So Mark, you’ve written about hurdle rates before. Could you explain what it is and why it’s so important?

LaMonica: Absolutely, Shani. So simply put, a hurdle rate is the return you need after costs and taxes from investing in order to beat the financial benefit you get by in this case, putting money into an offset. So in other words, if your investments can’t reliably exceed that hurdle rate, you’d be better off putting that money into an offset. And this number is important because you can think of it as an opportunity cost benchmark. So when you add funds to your offset, you are foregoing the opportunity to invest elsewhere, as Shani was saying. So the hurdle rate is the break-even investment return that makes that tradeoff neutral. And really the rate depends on, as we talked about, interest and taxes. So the interest rate environment we’re in, your marginal tax rate. So it’s not a fixed amount for everybody. We hear that a lot where people talk about it’s a fixed hurdle rate, it’s not.

It’s unique to you. So you need to calculate it on your own. So one of the attractive features of putting more money in your offset is that the interest rate savings are certain. So you need to consider that as well with that hurdle rate. It may seem like you can beat it, but you need to consistently beat it. So any investing, of course, returns are uncertain. And generally they’ve been good, but you need to take that into account. So think about if there’s a margin for error, if you think you can get 10% and the hurdle rate 6%, that would be great, for example. But yeah, make sure there’s a margin of error. Calculate your personal hurdle rate. And think about, we talk a lot about expected returns. Think about expected returns. Look at historic returns to try to figure out if that is actually something you can beat.

Jayamanne: And as we’ve been talking about, 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. So it is worth understanding all of your financial goals and how it fits in with your mortgage. So 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 the amortization schedule as a reminder of how mortgages work. It provides comfort, especially at the beginning of the loan, that we are making progress. And 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. And it is 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’re younger. So without oversimplifying it, it’s all about balance and understanding not just your end goals but the pathways to get there. And it’s about understanding the actions you’re taking and why so you can maximize your quality of life and your outcomes. And it’s not a revolutionary approach, but the offset is a fantastic tool that can be used as an appropriate part of your overall investment strategy.

LaMonica: So let’s think about finding your ideal offset amount. And obviously, this is different for everyone. So we’re going to talk about factors. We’re not going to come up with a number. So your ideal balance will depend on what life stage you’re in, your cash flow situation, your employment status, interest rates. So you’re obviously juggling, as Shani was talking about, a mortgage with other financial goals. So maybe why don’t we talk about you? Because people have to consider all these other factors. I, of course, don’t have a house. I mean, I live somewhere, but I don’t own it. But let’s talk about you. How have you figured out how much to put into your offset?

Jayamanne: Yeah, so we have a baseline amount and it consists of three buckets. So we have an emergency fund. Normally, the recommendation there is three to six months of expenses for salaried individuals, one year for self-employed.

LaMonica: And what have you gone with? Three or six?

Jayamanne: Four months. Four months.

LaMonica: Okay.

Jayamanne: Yes.

LaMonica: So conservative as I expected, Shani. So you talk about emergency funds a lot, which I guess is why I’m surprised. But we know all the things they cover. Job loss, you should be okay there. Medical emergencies, unexpected repairs, which is obviously a big problem in your life. So, okay, that’s one bucket, emergency fund. What’s your second bucket?

Jayamanne: So the second is upcoming short-term goals. So the next 12 to 24 months. So investments in equity markets that typically offer higher returns are just too volatile for this short time period. So putting it in the offset reduces interest expenses in that period and it maintains liquidity. So it could be an overseas holiday, maternity leave or like a random phase, not me.

LaMonica: Are you announcing something on the podcast?

Jayamanne: Just an example.

LaMonica: Yesterday, all day, Shani kept trying to tell me something. And then kept stopping.

Jayamanne: No, not pregnant.

LaMonica: You heard it here first.

Jayamanne: And then the last one is an everyday cash flow cushion. I use my offset account for lumpy costs that I know are incurred annually or every few years. So this includes home insurance, council rates, land tax, health insurance. And it can reduce interest while providing a place to save for these lumpy costs. And for me, every dollar above this should be carefully considered. So depending on your hurdle rate, it could be a better placed in other assets to grow wealth.

LaMonica: Shani is a very organized person, as you can probably tell from her three buckets in her offset account. But let’s finish this up. Let’s sum up the episode. So your offset account is one of the most flexible and tax-efficient tools that you have out there as an investor. So if you use it efficiently, it can shave years off of your mortgage and give you peace of mind. But that doesn’t mean it’s the best way to build wealth and achieve your financial goals. So once you’ve covered your immediate needs, as Shani talked about, then understand the rest of your funds, where the best place to put them. And think about those opportunity costs, those hurdle rates. So it could be that investing is a better choice to help your funds grow and compound as you also continue to pay off your loan.

So any other pearls of wisdom on offset account?

Jayamanne: I think that was it.

LaMonica: No other major life announcements.

Jayamanne: No.

LaMonica: OK, well, we’ll just finish this up then. Thank you all very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

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