Interest offset accounts (IOAs) are useful devices.
Interest offset accounts should be considered (and probably used) by virtually all clients in preference to paying a home loan off directly. One of the key reasons for this is that a home loan creates non-deductible debt.
Non-deductible debt is debt on which you can’t claim a tax deduction for the interest. That means you have to pay tax on your income before you can pay the interest.
Non-deductible debt is expensive debt. If the interest rate is 5%, and you are a 45% taxpayer (the highest tax bracket), the effective interest rate around 9% before tax. To understand this, consider an interest bill of $5000. A person paying tax at 45% has to earn $9000 in order to pay this bill. Of this $9000, they pay $4050 in tax to the tax office, leaving (virtually) $5000 remaining to pay the interest.
How Offset Accounts Work
offset accounts are incredibly simple. If you have a loan, and your lender has the facility available, you can link an ordinary savings account to that loan. The amount that you pay interest on then becomes the difference between the amount you owe and the amount in your savings account.
To give a simple example: if you owe $200,000 on your home loan, and you have $20,000 saved in an interest offset savings account, you only pay interest on $180,000.
From the point of view of paying interest, saving money into the offset savings account is the same as repaying the debt. However, because the money is in an ordinary savings account, you can continue to use it that money without needing to redraw from alone. So, for example, you might have your salary or wages paid into the offset account. Over the course of the month, you take money out of this account to pay for your everyday expenses (groceries, petrol et cetera).
A high rate of return – especially after-tax
Ordinary savings accounts often don’t pay any interest at all. An offset savings account effectively pays you the home loan interest rate. And if the interest is non-deductible, and the offset savings account effectively pays you the pre-tax home loan interest rate – which can be as high as 9%, as we saw above.
This is absolutely the best return you will get on money that is ‘at call.’ What’s more,
This becomes the effective rate of return on the money held in the offset account – easily the best rate of return achievable for a cash-based investment. And, best of all, the return is effectively guaranteed, because the return comes in the form of a saving. If there is money in the savings account, you will definitely reduce your interest bill.
In fact, depending on your tax rate, the effective rate of return rivals what is available in growth assets such as property or shares – a 9% return pre-tax is a good year in either the share or the property markets.
By the way, that is why the first order of business is always to reduce – or at least offset – non-deductible debt. The return on the ‘investment’ of debt reduction is unbeatable.
Interest offset accounts are also useful when you have deductible debt. But they are especially useful when there is non-deductible debt. So, if you have a home loan, talk to us about using an offset account to turbocharge your wealth creation.