One of the sacrifices we have to make when building a long-term fixed rate home loan is a reduced ability to add some extra features, such as an offset account to the loan. Whilst we don’t see this as a major issue (which we will show below) it was a sticking point with one bank we talked to. They told us “the offset account is important in case borrowers want to buy a boat!”.
This drives us to offer value in other areas, with features like no break fees, freedom to repay a fixed loan anytime and a fixed rate for 10 years. These all form part of our key value: borrowers get to fix the interest rate for 10 years but can switch or pay off any amount when they choose. This has a huge amount of value.
The history of the offset account is interesting and its use does make sense. Banks started offering offset accounts as a good way to combat non-bank lenders. An offset account, which is a deposit account and you need to be a bank or ADI to offer it, sits there and reduces your home loan exposure. If you have a salary being paid in, then the mortgage interest paid is reduced by the offset. More importantly, any savings you hold in deposit effectively attract the mortgage interest rate and are tax exempt (awesome).
For example (which we also use in our analysis later):
Home Loan Interest Rate = 4.0%
Best bank account savings rate = 2.5%
Tax Rate = 30%
If you didn’t have an offset, you would only save at 2.5% and be due to pay tax on those earnings, lowering the effective post-tax interest rate to 1.75% (2.5% * (1 – 30%)) for a 30% marginal tax rate payer.
Compare this to earning 4.0% with the offset account and looks like a good idea. But this is only a partial view.
We need to be careful: the borrower could simply just pay off some of the mortgage with those savings and then refinance to release the savings at a later date.
Alternatively, the borrower could invest those savings into other assets and earn a higher return, albeit with some investment risk. Finally, banks may charge higher interest rates to get access to offset accounts.
What we want to know: how much is an offset worth and does it make sense to go for one?
To do this analysis, the impact of the Offset is measured across 2 fields: the Salary Impact and the Savings Impact.
The first part to this is paying a salary into the offset account at the start of the month to reduce the loan balance. To make things easy, I will simply assume this salary is paid at the start of the month to give the largest possible impact. In practice, we would expect perhaps only 60% of the economic impact due to the loan balance reducing over the month – for example to pay off credit card and other bills.
We looked at 4 sets of households: low and high earners (in household terms) and each using an offset or not.
|Household||Household Income||Mortgage||Offset Account||Estimated CPR||Tax Rate|
|Low Earnings with Offset||$60,000||300,000||YES||15%||25%|
|High Earnings with Offset||$150,000||900,000||YES||15%||35%|
In addition, we also assume the non-offset household puts their salary into a savings account (at 2.5%) but pay tax on the interest earned.
To make a comparison, we reduce the interest rate of the non-offset household until the interest payments between the offset and non-offset households are essentially equal.
What we observe in these cases is the net benefit to the offset households is approximately 0.05% (5bps). If just savings methodology are applied, a household is 0.05% better off, each year, by using an offset account.
[To estimate this, consider $4000 paid in each month in salary. This equates to lowering the loan balance by $4000 for the life of the loan and saving 2.25% on that balance (4.0% minus 1.75%). Assuming $300,000 loan balance, this is a $90 saving per year on $300,000 = 0.03%. We used a more complex model that considered inflation to assess the impact, hence the higher value of 0.05%.]
CPR made little impact over observable ranges.
If we assume only 60% of the economic impact, the annual economic impact is reduced to around 0.03%.
The secondary impact is how savings influence the borrower and note that this is additional to the Salary Impact.
Assessment is harder as households could invest savings into non-cash assets. Cash in bank accounts is typically low earning as it is deemed to have very low risk whereas stocks and shares have higher risk but higher returns (and average to about 4-6% higher per year). Property has also increased significantly recently: should a borrower have savings or an investment property.
For our assessment, we will simply assume the borrower has savings in cash. For the offset account, there is a single approach as the mortgage balance reduces and the savings earn 4.0% without any tax implications (as 4% is the mortgage interest rate).
The non-offset borrow has 2 approaches:
- Pay off the mortgage and then redraw or refinance at a later stage as required
- Keep the savings in a separate account, get a lower interest rate (2.5%) and pay tax on the earnings
Within this, there are a few things to note. Paying off the mortgage is a good use of money if you have no desire to take additional investment risk in the short to medium term. If you do need to get access to the higher equity balance in your property, refinancing usually costs about $1500. You might get a free redraw access from some lenders (if you are not changing lender, the costs will be lower), so looking for redraw rather than offset is another option.
Keeping a separate savings account only makes sense if you want access to that money in the short term – notably within 2 years.
Combining the 2, if you know your approach, then we can find a maximum impact from not having an offset. If you need complete flexibility in the savings then there could be a far higher cost which we can then assess but do note: wanting full access and flexibility but not knowing how or when you will use it is possibly a poor approach – similar to leaving a large cash balance in your checking account.
Pay-off Mortgage and Re-Draw
The cost of this approach is based upon how often you re-draw/refinance and what the loan balance is. We assume each redraw $1500. We have set it out in years (how many years until the refinance/redraw is required):
|Loan Balance ($)||500,000||500,000||500,000||500,000||500,000||500,000|
We can then apply this across a range of values – with years along the top and the amount borrowed along the side.
|1 YEAR||2 YEAR||3 YEAR||4 YEAR||5 YEAR||6 YEAR|
I will revisit the results after Approach 2. Any borrower should take this approach as a maximum they should be willing to forgo for Approach 2: having flexibility costs money and this table shows you how much it should cost. It costs $1,500 to refinance and if the loan balance is higher or you plan to redraw very infrequently, simply wait until you need to redraw and pay the $1,500 – certainly if you save money elsewhere.
Keep Savings Separate, Pay the Taxes
Here, we assume you have savings as a percentage of the total loan balance, ranging from 1 to 20% and that borrowers will redraw every 2 years.
|% of mortgage held as cash||1%||2%||4%||5%||10%||20%|
|Cash Balance ($)||5,000||10,000||20,000||25,000||50,000||100,000|
|Mortgage Cost ($)||200||400||800||1,000||2,000||4,000|
|Interest Earned ($)||125.00||250.00||500.00||625.00||1,250.00||2,500.00|
|After Tax Earnings||87.5||175||350||437.5||875||1750|
|Cost per annum||0.05%||0.09%||0.18%||0.23%||0.45%||0.90%|
These tables present a lot of data but it can be simplified into 3 sections:
If you have a very low savings balance (1-2%), using the offset has less value as you are not saving much money. We assume this is at best 0.1% per annum benefit in having an offset.
If you have reasonable savings, which comes to about 5% of your outstanding mortgage, the potential cost of this approach is 0.18% to 0.23% per annum (18bps to 23bps). From this point onwards, the decision is then a matter if the redraw will be made in Year 1 versus later. If you expect to redraw within a year, Approach 2 (savings & tax), otherwise Approach 1 (redraw/refinance). This caps the cost at about 0.15% (from Approach 1) as the 1-Year cost for Keep Savings in this second bracket is 0.1% and the maximum cost for Approach 1 is 0.15% if over 2 years (less if longer).
Generally, if one has a very large savings balance (10-20%) then there is limited point in borrowing. You are essentially giving the bank money by receiving 2.5% and paying 4%. Here, the best approach will be to use the redraw strategy (Approach 1) as the total cost is $1,500 and we expect the cost to be around 15bps as a maximum and reduce if you infrequently need access to the savings.
Offsets do add value to a borrower in that the tax benefit of reducing a liability is better than receiving interest and that interest us a lower rate than you pay.
By combining our assessment of Salary and Savings Impact, the offset puts a borrower in approximately 0.2% per annum better off: a borrower should be willing to pay up to this for the product.
There are several caveats around this:
If the savings balance is very low, the impact is reduced to about 10bps.
If the savings balance is proportionally higher, the borrower needs to consider what they are going to do with their savings: keeping large savings in cash deposits is not an optimal choice. If these savings are put into equities and earn 7% per annum, then the value of an offset account is reduced but the borrower is taking on a different financial risk that we cannot easily compare.
If you are a conservative borrower who doesn’t plan to redraw, the offset benefit may reduce to less than 10bps.
If you have other types of debt, you are better paying them off than reducing a mortgage, which typically has the lowest interest rate.
You may get access to free redraws in some home loans. Then benefit of an offset versus these is then reduced to 0.03%- 0.05% as we can use Approach 1 without facing the $1,500 cost.
Applying to a Family
Consider a family with household income of $150,000, 35% tax rate, $625,000 mortgage, $35,000 of savings and refinance frequency of 3-years.
An offset will save them:
Salary Impact: $2,264 or 0.05%
Savings Impact: Approach 1 is 0.08% (note: Approach 2 is 0.40%)
Total Impact is 0.13%, so they should only choose an Offset if the interest rate is less than 0.13% higher than a non-offset account.
What are banks charging?
The cost of an offset account ranges from 10bps to 40bps, so you need to consider if it is worthwhile versus going for the more simplified product. If a bank is charging more than 0.15% it is likely to be a financially negative decision to choose an Offset account (banks are known to gauge customers) as the bank is charging more than the likely benefit. We think most banks are charging 0.2% to 0.25% extra for offsets, so see them as being a pointless exercise unless combined with a split loan (we’ll save this for a separate blog).
Like many things, the borrowers view on how often they need to draw money is key and if the standard non-offset product allows the occasional redraw, this will help answer the question.
It may also be worth picking other loan products with no offset feature at all if they offer features that outweigh the offset’s value. The easiest example is a fixed rate product: if you think interest rates will increase, then a fixed offers potential value as those interest rates won’t go up during the fixed period.
Huffle’s FlexiFix home loan product goes beyond this. We offer the certainty of payments and the flexibility to pay off and refinance without any break costs. We believe this has substantially more value to a borrower than an offset account.