While both options reduce the interest on your loan, the similarities stop there. Offset accounts and redraw facilities operate very differently from one another and using the wrong one can have serious consequences.
Many in the finance space will use these terms interchangeably and suggest that there is little difference between using one instead of the other. This is incorrect.
One should understand the differences between the two, particularly the impact of money being removed from these structures, before making a choice on which to use.
Redraw Facility
What is it?
Put simply, a redraw facility is when a bank allows you to access any additional repayments made on your loan. If your bank allows for redraw, and you make an additional repayment of $10,000, you should see that $10,000 now being accessible from your loan account.
Any additional money paid off a loan will reduce the interest payable, even though it remains accessible through a redraw facility.
Let’s say you have a loan worth $500,000 with an interest rate of 6%. You would then be incurring $30,000 worth of interest each year. If you make an additional payment of $100,000 into the redraw, your total interest payable will reduce to $24,000.
The interest is now only calculated on $400,000. This means that any money in the redraw gives you a guaranteed after-tax return equal to that of your interest rate. This makes it an attractive prospect for effectively using a redraw as a savings account – considering that the rate of return would be higher than a standard bank account.
However, although the loan balance is lower – it’s likely that your minimum repayment will remain the same. Why is that?
Impact on Repayments
When you take out a loan on a principal and interest basis, the minimum monthly repayment is calculated based on the loan term and the interest rate applicable. Assuming the interest rate stays the same, at this minimum repayment it would take you the entire loan term (usually 30 years) to pay off the debt.
This minimum repayment is made up of both a principal component, and an interest component. Logically, at the start of the loan most of the repayment will be toward interest – as this is when your loan balance is the largest. Over time, as you pay off the debt, the interest portion will decrease, and the principal portion will increase.
Extra payments into a redraw facility do not lower your minimum repayment. However, it shifts the allocation of future repayments toward the principal, as less interest is being accrued.
The benefit of storing money in a redraw facility is that you will pay your loan off earlier at the same repayments simply because less interest is accrued.
This differs somewhat for interest-only loans because there is no principal repayment to the loan, it is only interest. Money in a redraw for an interest-only loan will directly reduce the interest payments and thus can help for those with immediate cashflow concerns. The loan will not be paid down over time though.
Impact of Withdrawn Money
This key difference between redraw facilities and offset accounts is crucial to understand.
Money withdrawn from a redraw facility is considered a new loan for tax purposes. Again, for effect. Money withdrawn from a redraw facility is considered a new loan for tax purposes.
This has many implications, both good and bad.
Starting with the good, this feature allows for a strategy called debt recycling. This is explained in more detail here. Briefly, debt recycling allows you to convert non-deductible debt (like a home) into deductible debt. This involves using your home’s redraw facility to deposit money into, then withdraw it and invest. The resulting interest of this ‘new’ loan will be tax deductible.
It goes the other way though. If you put money into a redraw facility on deductible debt (like an investment property), then withdraw it and spend it on non-tax-deductible things (like holidays, or cars) the resulting interest will not be tax deductible.
This also applies for future usage as well. If you remove money from a non-deductible (home) redraw and spend it on personal expenses, you will run into issues if you want to turn that property into an investment property in the future. The deductibility of your debt will not be your total debt in such a scenario, instead it would be the total debt less the debt attributed to the money that was redrawn for personal expenses.
The general rule is to not use a redraw facility on your home if you intend on turning it into an investment property in the future.
Risks
Funds in a redraw facility are technically no longer yours. It is money that the bank is letting you take back out of your loan. Whilst this would be a rare occurrence, a bank could theoretically deny you access to those funds.
Another potential risk is loss of access once the loan is paid off. Once the loan account is gone, so goes the redraw facility and the access to the funds. To access them again you would need to take out a new loan with the bank which could be difficult depending on personal circumstances.
Offset Account
What is it?
An offset account is a bank account that reduces interest on a linked loan rather than earning its own interest. Money placed in an offset account will have the same effect as money in a redraw facility. Therefore, the same benefits of reducing interest payable applies for an offset.
One large difference however is that money paid into an offset account is not directly being paid off the loan. This means that you can have a loan that is fully offset, or even an offset account higher than the loan balance, although there is no benefit to this. This differs from a redraw facility where if the redraw equals the loan balance, it is likely the bank will close the loan completely.
An additional benefit for offset accounts is that because it is a bank account, it is protected by the $250k government guarantee on deposits, provided it is an account issued by an approved deposit-taking institution (ADI). Some offset account products are not provided by ADI banks, and thus aren’t protected, so it’s worth checking.
Depending on the bank, you may even be able to open multiple offset accounts that reduce interest on a single loan. This would make it considerably easier to manage different savings buckets whilst also minimising interest payable.
Impact on Repayments
Offset accounts affect repayments in the same way as a redraw facility.
For principal and interest loans, minimum repayments will remain the same with the proportion of interest vs principal changing in each payment.
For interest-only, money in an offset account will directly reduce the interest payable and thus the repayment needing to be made each month.
Impact of Withdrawn Money
As mentioned earlier, this is where an offset differs most from a redraw facility.
Unlike a redraw, withdrawing from an offset doesn’t alter the loan’s nature. This naturally means that debt recycling cannot be achieved through an offset account.
However, it also means that money removed from the offset account of a deductible (or future deductible) loan will not affect total tax deductibility. If you have a fully offset loan on an investment property that is paying no interest, you could purchase a car with that money and the resulting interest payable would still be tax deductible.
This flexibility makes offset accounts particularly useful if the only debt you have is already tax-deductible. If you only had access to a redraw facility, you would only want to deposit money you had no future need for whatsoever. With an offset account, you could use this as a high-interest savings account for any funds, as any withdrawal for any purpose will not affect its tax deductibility.
Risks
Firstly, there is usually an additional fee payable for an offset account compared to a redraw facility, often called a package fee. The most basic loan options, usually those with the lowest rates, often do not offer an offset account at all.
Outside of that, there are very few structural risks associated with an offset account.
However, there are situations in which a bank has not properly associated offsets with loans and thus has not provided the promised reductions in interest. This can be easily checked though whenever a new offset is being used. Take note of the interest being accrued in one month, then again, the next month after the money is added.
Summary
When it comes to saving interest on a loan, utilising an offset account clearly offers a greater level of flexibility with a lower risk of future tax deductibility and accessibility issues. However, it often comes with an additional monetary cost in the form of a higher interest rate or a package fee, when compared to a redraw facility.
For example, with an annual $300 package fee and a 6% interest rate, you’d need about $5,000 in your offset account year-round to break even on that cost.
This should be taken into account when choosing between a redraw and an offset. If you’re not easily saving more interest than the package fee, then perhaps a redraw would be more appropriate.
Most importantly though, if you intend on turning your home into an investment property at any point in the future, be very careful using a redraw.
