In this episode of Financial MasterClass, we wanted to explore one very important aspect of financial planning, your cashflow and at the same time thought it would be a great idea to discuss exactly how does an offset account work?
One of the tenets that underpins all that we do, is the concept that you need to spend less than you earn. This is a key ingredient in any financial recipe, and without it there is no way to create a plan with any certainty. So if you are on board with spending less than you earn, and doing something awesome with the balance, then let’s get started!
How does an offset account work?
This example is designed for someone that owns a property, however the principles could be used with your standard transaction and savings accounts. For home owners though, it all starts with your offset account, so let’s first define it. A mortgage offset account (also known as a home loan offset account) if used properly could save big dollars and years from the life of your home loan – but how does an offset account work, and how can effective cashflow planning make the most of the offset strategy?
Typically when you take out a standard variable home loan, a transaction account will be opened and linked to this loan. This account will be identical to any normal transaction account – you’ll receive a bank card and be able to withdraw money from ATMs or conduct EFTPOS transactions, access internet banking for paying bills via BPAY or transfer money online. Some accounts give you a Visa Debit card, so you can make purchases like a credit card, but instead of racking up a credit card bill you are using your own money from the balance in your account.
The true benefits lie with your loan however. The money (or balance) in your account is offset daily against your loan balance, and this will reduce the mortgage interest charged accordingly. So you might have a $500,000 loan and $50,000 in your offset account. Because of your offset account, you will only be charged interest against $450,000. And, if you are making set principal and interest (P&I) repayments on your loan each week/fortnight/month, your repayments will consist of a reduced interest component, and therefore you will be paying more off the loan principal with each repayment.
By having a decent amount of money in your offset account, you can effectively cut years and thousands of dollars from your home loan and at the same time have a strategy to provision for holidays, fun stuff and rainy days just in case something happens – instead of having every single dollar going into your mortgage. Knowing you have monies set aside is empowering and provides you with choices.
The best way to use an offset account
Offset accounts work particularly well if you have your salary deposited into the account every payday, and then allocate funds to separate accounts according to your requirements for day to day living, holidays, investing and other expenses. The banks want you to use your offset account as the hub for your spending, so it’s time to take control and turn things around 180 degrees and use the offset account as the hub for your savings.
Your cashflow, and how to use your offset account.
To assist with cashflow planning, we often structure multiple offset accounts linked to the variable home loan (see diagram) – although not all lenders allow you to do this so it’s important you look for this feature in your lending package (interest rate alone is not the only factor when shopping around for a new lender!). For example, you may have an ‘everyday’ offset account which is where your wages are paid into, and general living expenses are paid out but you have other offset accounts for long term savings, holiday funding and provisioning for other big ticket expenses. This removes the temptation of spending money that is actually earmarked for other purposes.
Tip: better still, use a fee-free credit card with an interest free period to pay your living expenses, and then pay this off in full on the due date each month. That way, you have your money sitting in your offset account for longer saving you more in interest and it’s a guaranteed after tax return that is the same as your home loan rate! It’s also a good idea to keep any extra short-term savings in an offset account too; you can set up a regular transfer set up from your ‘everyday’ offset account into your ‘savings’ offset account. You’ll find that you’ll never earn as much in interest on your bank savings as what you are paying in interest on your home loan.
If you can take these tips on board and take action, you will know all that is needed and easily be able to answer the question how does an offset account work? All of the major banks (ANZ, CBA, NAB and Westpac) will offer offset accounts, as will the majority of other domestic lenders (Credit Unions, Building Societies, Regional Banks etc), however not all will off multiple offset accounts.
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