Over her long career as a TV money commentator and national newspaper columnist, Nicole Pedersen-McKinnon has learned a thing or two about the potential traps of mortgages and ways Australians can avoid them. She put that knowledge to good use and paid off her mortgage in seven years.
In her book, How to Get Mortgage-Free Like Me, Ms Pedersen-McKinnon shares the strategies and shortcuts she used to ditch her mortgage quickly. The book also includes insights and inspiration from a number of families about how they too have beaten a mortgage.
In “Step 4: Secure the mortgage-busting secret weapon”, Ms Pedersen-McKinnon looks at how a mortgage offset account works, how much you could potentially save and the potential advantage of using an offset account if you plan to convert your home to an investment property down the track.
Here is an edited exclusive excerpt from that chapter, republished with permission.
SO I’m beyond excited it's 24 hours until I launch my new book 🤗The earlybird discount is available a few more hours at https://t.co/cVM3APjuyV 🎁
And courtesy of @YahooFinanceAU, here’s a video taster on how to pay your loan down the RIGHT not WRONG wayhttps://t.co/QfRVHsn4TQ pic.twitter.com/X0D15Omv7K
— Nicole Pedersen-McKinnon (@NicolePedMcK) December 30, 2019
How does a mortgage offset account work?
The mortgage offset account, an Australian innovation that’s now been adopted across the world, has changed the face of debt reduction.
This magic little “account” lets you use every dollar twice… both for its intended purpose and to dramatically reduce your mortgage interest.
And it’s in one of these remarkable facilities that you should house every dollar in cash you have to your name. Because all at once, it can act as a home for your:
- Emergency or Holy Sh*t fund – this should preferably be equal to six months’ salary, so you could live comfortably for that long if you faced a Holy Sh*t money moment
- Savings for your next car
- Savings for any future discretionary spending, such as big holidays
- Savings for a deposit on a new home down the track (and we’ll also get into why you would do this – rather than pay extra directly on to the mortgage – in a moment).
A mortgage offset account allows you to use all this money to reduce your mortgage interest.
And reducing your mortgage interest is a far smarter move than just about any investment – at a long-term average 5% mortgage interest rate, higher rate taxpayers require a historically large before-tax investment return of 9%pa before they would be better off investing than repaying their mortgage.
If you shop around, you should be able to get a loan with an offset account at a very competitive interest rate (and fee-free); even if you have to pay slightly more, if you hold all the above in offset accounts and – vitally – deposit every extra dollar you repay into an offset too, you should come out far ahead. But we’ll get to that bit!
And an offset account well and truly kicks a regular savings account’s butt. Your saving is roughly 2% more than you’d earn on deposit… and it’s tax-free.
OK you’ve made your point, you’re probably thinking. But how does an offset actually work?
An offset account is simply an account that runs alongside your loan. Any money you hold in such an account is “offset” against the money you owe – so you pay no interest on that amount. For example, if you have a $100,000 loan but $10,000 sitting beside it in an offset account, you’ll only pay interest on $90,000.
Hang on, so I’d get the same benefit as putting money directly in the mortgage?
Sure would. The benefit is mathematically identical. In other words, you’d still make a tax-free effective return equal to the interest that you’d save.
What is the difference between using offset and putting money directly in the mortgage?
There are two very important differences if you use an offset account:
- One, you retain complete access to your money, and
- Two, the loan is never technically paid down. The reason the latter is vital will become apparent in a sec.
You, like many others, may think that by making extra mortgage repayments, you are protecting yourself against rate rises and loss of income. The idea is that if you’re ahead and you get into financial strife, you could stop repayments for a while.
Well, you can’t unless the bank explicitly waives the requirement after negotiating with its hardship department. You are contracted to make a monthly repayment come what may.
Of course, it may be possible to redraw what you have overpaid, sometimes for a fee, and drip feed it back in. But this is far from certain. Some loans don’t allow it, and even with loans that do, lenders can stop you from taking out overpayments if you’re no longer working, preferring to reserve that money to protect themselves. It’s in the fine print of many loan documents.
So at the very time you need it most, your money might be locked away from you.
Even if you do something as seemingly innocuous as take a repayment holiday, that extra money is likely to be swallowed up. Lenders may well recalculate your repayments at the end of the holiday on a balance that includes your overpayments.
Indeed, mortgages can act like one-way trap doors.
The only way you’re guaranteed to retain access to your money is with an offset account.
Okay, that’s scary, you rightly complain. But what was that thing you said about never paying down the loan… I want to pay down my loan!
The benefit of offset if you plan to convert your home into an investment property
So probably the most compelling reason to make extra repayments into an offset account, as opposed to a regular or transactional mortgage, is this. When you hold extra repayments and savings in an offset account, your loan balance doesn’t actually fall – it is only deemed to fall.
Now this is an absolutely crucial distinction if there is even the faintest chance that, at some point down the track, you will convert your home into an investment property.
By reducing your loan balance, you are cutting yourself out of any tax deductions in future and committing an easy-to-avoid mistake that will cost you thousands of dollars a year.
It’s all because you are only able to claim interest deductions for investment properties on your lowest-ever balance.
So if you pay it down, you lose them forever. You are basically committing to living in a home forever or, very possibly, having no choice but to sell it.
How do I avoid all this then, so I keep some flexibility to move out later?
Once more, by making extra repayments not directly into your mortgage but into a mortgage offset account. This way, your old loan will not have dramatically reduced when you eventually want to purchase a new home and may choose to convert the old one to an investment property. Your deductions will be safe and you will have a cash deposit for your new home. (Plus, for six years from the day you move out of a property, you can sell it without triggering capital gains tax and if you move back in, you could get another six years.)
How much you can potentially save using mortgage offset
Make multiple offset accounts part of your mortgage-freedom blueprint. You can sometimes have up to 10 for individual, clearly named purposes. We used to have an offset for “bubba booty”, when we were expecting our first child, and a “fun fund”. And don’t get an ATM card if they offer!
If you can scrounge $30,000 to sit in offsets against the average $400,000 loan – your savings for any Holy Sh*t moments, and for your next car, holiday and possibly even home – you’ll save $66,000 and shave 2.5 years off your loan term.
For free? I’m doing it!
About Nicole Pedersen-McKinnon
Nicole Pedersen-McKinnon is a long-time TV money commentator and national newspaper columnist. She is the author of How to Get Mortgage-Free Like Me (RRP $24.95).
Main image source: unge255_photostock (Shutterstock)