If you are buying a home that you may later turn into an Investment Property, not understanding the difference between a redraw vs offset could cost you tens of thousands of dollars in lost tax deductions.
When you get a home loan, you can put your spare cash to work earning a higher interest rate than a bank account. If your high interest savings account offers 4%, and your loan interest is 5% (which is the way banks make money), by using an offset or redraw, you are effectively getting a higher interest rate by way of paying less loan interest. In fact, it is better than that – with your savings account, you have to pay tax on the interest, but with an account that reduces your loan interest, there is no tax to pay, so if you are on a marginal tax rate of 34.5% (including the Medicare levy of 2%), you are effectively getting a pre-tax return of 100/65.5 x 5% = 7.6%
There are two types of accounts that can accomplish this: a redraw facility and an offset account, and it is critical to understand the difference.
Redraw vs Offset
An offset account is legally a savings account. Any money in there is still your money, and you can take it out whenever you like without restriction.
Paying money into a redraw facility, on the other hand, is legally considered paying down the loan, and it belongs to the bank, not you. It is secured extra repayments for the bank. There are two consequences to this.
- The bank can decide not to allow you to redraw it out (yes, this happens, particularly if they see a change in your spending patterns on a credit card from that bank indicating you may have lost your job, which incidentally is the time you desperately need the money); and
- When you take money out, it is considered a new loan for tax purposes. If this newly borrowed money is used to purchase income-producing assets, the interest is tax-deductible, otherwise it is not.
Note that some smaller lenders offer a product that they call an offset but is actually a redraw. This is often the case with lenders that are not Authorised Deposit-taking Institutions (ADIs), and do not hold your offset money in a separate account. You could be locking up a considerable amount of money without realising until it is too late. Always check the fine print.
The costliest mistake
If you are buying a home (also called a Principal Place of Residence or PPOR) that may later be turned into an Investment Property (IP), you need to prepare in advance to avoid a common mistake that can cost you a fortune in lost tax deductions. This cannot be fixed up after the mistake has been made.
What determines whether loan interest is tax deductible is whether you borrow the money to purchase an income-producing asset or not.
Let’s say you buy an IP with a loan of $400,000. Since an IP is an income-producing asset, the interest on the loan is tax-deductible. If you save $50,000 into a redraw facility (which is legally considered paying down the loan) and later want to take the money out for a holiday, a new car, or any other non-investment purchase, the interest on that portion of the loan is no longer tax-deductible. because when you take money from a redraw, it is considered a new loan, and if the money is used to purchase something other than income-producing assets, the interest is not tax deductible.
Let’s say that instead, you put that money into an offset account. Since an offset is legally a savings account and not considered to be paying down the loan, if you take out that $50,000, the delectability of the interest is restored.
The most significant consequence of this is where you buy a PPOR and later buy a new PPOR and turn the current PPOR into an IP.
As you want your money offsetting your non-deductible debt (because you get a much higher pre-tax return on non-deductible debt as in the calculation above), you would want as much as possible paid off (or in an offset) on your new PPOR rather than against the IP. Had you saved your new PPOR deposit and other repayments into an offset in your previous PPOR, you can just transfer it across when you move and this would restore the tax deductibility of the loan interest on your IP. Had you put it into a redraw, when you move the money, the tax-deductible is not restored, and you would lose those tax deductions for the life of the loan.
We’re talking about tens of thousands of dollars in lost tax deductions here over the course of a 30-year mortgage.
To take this one step further, if you are in the planning stage of buying a PPOR that may later become an investment property, you want to pay down the minimum possible into the loan and instead put the cash into an offset so when you buy the new PPOR you maximise your tax-deductible debt. Since stamp duty is often around 5% of the value of a home, tax advisers will often use the phrase “borrow 105% of the value of the home”, meaning putting down nothing and instead keeping it in an offset (not a redraw).
The risk in doing this is if you don’t have the discipline to leave your cash alone based on the understanding that it is earmarked for your next PPOR purchase and spend it frivolously. That’s going to be worse than paying down the loan. If you have the discipline not to spend it, the tax advantages of borrowing 105% of the home and utilising an offset can provide enormous tax deductions (provided you are able to borrow 105% – if you don’t have equity to borrow from, you will just want to minimise whatever you put into the loan and keep as much as possible in an offset).
Once the loan is paid down, you can not undo this mistake. If you pay it down rather than use an offset, and later borrow it out to use for something that is not an income-producing asset (such as a PPOR), it will not be tax-deductible, and you will lose the tax deductibility for the life of the loan.
You can not undo this by taking it out of the redraw facility and moving it to an offset account. Once it has been paid down (which is what happens when you put it into a redraw facility), it is a new loan even if you take it out and put it into your offset before using it.
Offset accounts are more expensive
While an offset offers you the flexibility of turning your PPOR into an IP while retaining tax deductions and allows you to use your account to receive your salary and pay bills from, the downside to using an offset over a redraw is that some banks have a higher loan interest rate for accounts that offer an offset compared to those that offer redraw-only. Additionally, most banks charge an annual fee for an offset account in the neighbourhood of $395 p.a. These fees can add up, so it is in your interest to think about whether these tax consequences may affect you.
If you are unlikely to turn your PPOR into an IP and you will only use the offset account for a small emergency fund, it may be better not to use the offset account option and just keep your emergency fund in a separate high interest savings account (HISA) to ensure access to that capital. This would be suitable if the lower amount of interest earned in the HISA is more than made up by savings of using a redraw-only home loan at a lower interest rate. You can determine this by comparing the different interest rates for a redraw-only loan and a loan with an offset account.
A redraw is appropriate if you don’t need to guarantee access to your funds and your purpose is purely to reduce interest by paying down the loan. Redraws are one of the most misunderstood financial products due to the mistaken belief that it is equivalent to a savings account, and the tax consequences of keeping savings in there.
An offset is appropriate if you have a significant amount of cash to offset, where the interest saved is higher than the added cost of having an offset, or where you want to retain the flexibility to maximise your tax deductions in the case of the potential to turn your property into an IP in the future. If you are unsure, I would err on the side of caution and go with an offset.
In a nutshell:
- Both a redraw and an offset offer the ability to get a much higher return than a high interest savings account. They both offering the same advantage in this respect.
- Adding money to a redraw facility is legally considered paying down the loan and has significant implications for access to your money, and tax deductibility for an investment property or for a property that may become an investment property in the future.
- Adding money to an offset is simply keeping your money in a savings account that happens to offset the interest payable. you retain access to the money, and you can restore the tax deductibility in future when you take it out.
- A loan with an offset often has either a higher rate, an additional annual fee, or both. So if you’re sure you will never turn your property into an investment property and you will not be keeping much money in there, it may not be worth it.
- One further difference not mentioned above is that with some lenders, redraw accounts reduce your minimum repayments, which are recalculated based on the original loan term but with less money owing. This does not happen with an offset as you have not actually paid down the loan. So this could improve your cashflow in the long term. Although, in the short- and medium-term, money in an offset could be used to improve your cashflow anyway, and it is more sure to be available.