Owning a home mortgage used to be the reserve of individuals who had healthy initial deposits of 40% tucked away in a bank account; just ask the baby boomers.
Not anymore though. Nowadays with banks under pressure to deliver the billion dollar profits they’ve come to be famous for, the rush to loan money out has been relentless. As I write this, NAB is offering a $1,000 cash-back offer for customers who refinance a mortgage with them between 12th August and 30 September. Commonwealth Bank (CBA) had a similar deal (which has since expired) offering an even better $1,250 cash-back to customers.
With offers like these coupled with government interest rates at historic lows of 1.50%, it shouldn’t come as a shock that around 33% of Australians own a home mortgage. Combined with the inherent love in owning a property of their own, it’s easy to explain why the Australian household debt now makes up 190% of a household disposable income.
That is, the average household owes debt that is almost twice their wage!
I regularly get asked a question on “I have many forms of debt; which one do I pay down first exactly?“.
Well the short answer is to pick the debt that costs the most in terms of interest rate payments. One of the first things I do is to determine whether my debt is considered bad or good debt?
Bad debts include examples like payday loans and personal credit card balances where it costs in excess of 15% interest on any outstanding balances. These expenses are also usually non tax deductible so there are really no benefits of holding onto these sorts of debts.
Good debts on the other hand are typically attached to value appreciating assets such as property or shares; assets that are expected to grow in value over time. Furthermore, if such assets are purchased as investments, the ATO reward investors with allowable tax deductions to sweeten the transaction.
In essence I would always run these questions through my head; “1) Good or bad debt?, 2) interest cost of holding onto debt? 3) is the interest tax deductible?” which likely results in me paying off bad debts first which costs the highest interests and is non-tax deductible.
Secret to offsetting weight off your mortgage
Seeing that over a third of Australian households own a mortgage, it’s really important to have a proper strategy in place to manage the risks at hand. If jumping into the property market is what you want to do, then you need to tackle debt the right way.
And that brings me to my topic of today on mortgage offset account and how using it effectively will be the secret to offsetting weight off your mortgage. What exactly is an offset account you ask?
Wikipedia officially defines the term as;
On the surface it may seem like just another bank account but using it wisely is probably one of the best strategies available to a mortgage account holder for paying down debt faster. It’s the secret to offsetting weight off your mortgage that many people don’t know about.
As the above example shows, an offset account with $50,000 attached to a $500,000 mortgage costing 5% interest per year will help you save $2,500 a year.
Using an offset account will allow you to efficiently pay down debt without incurring unnecessary extra costs. It will allow freedom of funds movement. It will also allow a good return. In short, it’s awesome and here are some of the reasons why;
Awesome fact #1 – A guaranteed return yield
When looking at where best to put my money, the return yield is always one of the first things considered. Because a cash balance in an offset account directly reduces the principle amount of a mortgage, the effective return yield would be that of the mortgage interest costs. In the above example, this would be a guaranteed 5% return yield on cash balance. There aren’t much investments out there that can return a 5% yield, let alone it being a guaranteed return.
Awesome fact #2 – Efficient use of cash
There many banks that offer different variations of offset accounts. My personal favourite is Commonwealth Bank’s Everyday Offset account which provide dual benefits of being a full transaction account with inbuilt mortgage offset features. With it being a transaction account, I can use it for my everyday needs like direct debits, withdrawals, and EFTPOS without needing to open up another separate account.
Additionally, the account comes with an offset features which also allows me to receive a 5% (again using the above scenario) return on every single cent that I contribute into the account. In a nutshell, an offset transaction account offers me the convenience of having all my money concentrated in one spot to maximize the return on my cash and therefore paying down my mortgage faster.
Awesome fact #3 – Compounding effects
Part of the reason why a mortgage with an attached offset account gets paid off quicker is because every cent within the account is being used to actively reduce my interest costs. I talked about the miracle that is compounding in my previous post. Using the very same logic, the longer I leave my cash in the offset account the bigger the compounding effect, and over time this benefit will shave off years from my mortgage.
Awesome fact #4 – Always have access to your cash
Now having a mortgage is a big responsibility, and one that I take very seriously. But that doesn’t mean that I should let it stress me out though! We all need to relax and have fun once in a while, and having access to an offset account makes that easier. Because offset accounts are just like normal bank accounts, I can access my cash anytime without having to go through the arduous process of a mortgage redraw which generally requires physically attendance at a branch to complete.
Awesome fact #5 – Untaxed financial benefit
And the last but definitely not least awesome fact of using an offset account is that any financial benefits gained are untaxed by the ATO. This is because the benefits received are interest cost savings instead of interest income; a subtle but very important difference. Both are equally valuable in dollar terms except for the fact that one is taxable and one is not.
Again using the example above, the interest cost savings of $2,500 is non-taxable as it is not considered income that is received. Conversely if $50,000 was placed into an interest-bearing account that returns $2,500 as interest income, that would be taxable.
So elaborating it in numbers, the net dollar value you’d be getting via an interest cost saving is $2,500 compared to interest income $1,750 (assuming 30% tax rates). Pretty clear value there.
It’s not impossible . . .
As depressing as it may sound, big mortgages are unfortunately part of living in Melbourne, or most major cities around the world for that matter. Yes taking on a huge mortgage is risky and it may seem like an eternity before any meaningful amounts are paid off. While the process may seem daunting, the positive thing is that it’s not impossible to manage a big mortgage. Many individuals before us have done it in the past, and many still continue to do so successfully.
It all starts with having a proper strategy in place to pay down debt as fast as possible. At a time where there are many complicated strategies available for mortgage holders, it’s refreshing to see something as simple (but as effective) as a mortgage offset account.
So start there first, and you will be well on your way to managing a big mortgage successfully.