Every six months or so, my husband brings up paying off a chunk of our mortgage in a lump sum. I argue in favour of the offset account. It’s a well-rehearsed dance:

Me: “But if we pay off a lump sum, if we need that cash we’ll have to redraw, and maybe the bank won’t let us.”

Hubby: “But if we pay it down, we can drop our mortgage repayments.”

Me: “What’s the point in that? You’ll be charged the same amount of interest either way.”

Hubby: “How can that be? Surely I’ll be charged less interest if I pay it off?”

Me: “You’re not paying interest on that chunk now. Everything in the offset, is OFFSET – you don’t pay interest on it!”

…at which point we abandon the discussion.

Until next time.

When the last ‘next time’ came around, I decided to settle this debate once and for all in the same way two engineers have settled arguments since time immemorial.

I created a model.

With clearly stated assumptions.

In a spreadsheet.

(No, not Matlab – I’m not THAT sad.)

We finally hashed it out and have landed on our strategy for our home, which is:

• We keep the money in the offset.

• When we get over $250,000 in the offset and if we’re feeling we won’t need the money for 6mo+, we will pay a chunk off the mortgage to bring the offset account balance back down to $250,000.

• We will keep paying the mortgage at the original home loan rate for as long as we can – even if we pay down a lump sum.

(Why $250,000? See the risks associated with offsets at the end of this article).

That’s the strategy we will follow, but it may not be the right one for you.

To help you decide what it right for you, I’ve written the following detailed blog.

But first things first: how does an offset account work anyway, and why should you care?

You should care because you’re paying interest.

How interest works on a home loan

If you have a mortgage, you are being charged interest by the bank each month.

To gauge how much this is: most loans that are standard terms (25 – 30 years) will mean you pay off around twice what you borrowed at an average interest rate of 6-7 per cent.

So, your repayments over time amount to half interest and half principal.

As you make your regular weekly, fortnightly or monthly payments, you’re paying off a bit of what you owe. This reduces the amount of interest you will be charged.

When you do the calculation at the bank, they tell you an amount you’ll pay each month, every month, until the loan is discharged. It’s a regular payment, always of the same amount.

But that’s not how the interest is charged – it’s not linear.

You’re charged most of the interest in the first 10 years of your 25-30 year loan, during which time the principal (the amount you owe) remains depressingly high. But soon enough the scale tips, and you’re paying off decent amounts of principal and the interest charged is dropping.

It is in your interest to reduce that interest charged as soon as you can, especially on your home loan as this has no tax benefits in Australia (if you’re not debt recycling - that’s a topic for another time).

Ways to reduce the interest you pay

There are three options to pay less than the amount of interest due on the full term of your loan:

1. Pay more than your minimum monthly repayment,

2. Pay off a lump sum, or

3. Use an offset account.

Method #1: Pay more than minimum repayments

One slow-and-steady way to reduce the interest you are charged is to add more to your regular payment.

An extra $10 or an extra $1,000 on top of your minimum repayment has the same directional effect: less interest charged and paying off the loan quicker.

It’s just a matter of scale: the more you pay, the quicker the loan comes down.

This affects cash flow. You have to find that $10 or $1,000 (or whatever it is for you) from your current income.

Another subset of this option is to switch to fortnightly repayments that are half the value of a minimum monthly repayment. This is like making 13 monthly repayments in the year instead of 12. It’s my favourite sneaky way to get ahead.

Method #2: Pay off a lump sum

Sometimes, you may find yourself with a chunk of change in the order of thousands of dollars. Perhaps you sell a toy (e.g. jet ski, boat), or you get a bonus at work, or you get some inheritance.

You could use that chunk to pay off a part of your mortgage in what’s called a lump sum payment.

This reduces what you owe, and therefore the interest you’re charged.

Because the time period of the loan remains the same but the amount you owe is less, the minimum repayment required drops.

You could then do one of two things:

• Option A: Keep making the original repayments, which then becomes like method #1 as you’re effectively paying more than minimum and therefore pay the mortgage off quicker, or

• Option B: Switch to the new lower minimum repayment, so you pay less but over the full term of the loan.

Option 1 results in the least amount of interest charged.

Method #3: Put the lump sum in an offset account

Instead of paying off some of the balance of your mortgage, you use an offset account.

This is a savings account linked to your mortgage. As the name implies, it offsets the balance on your mortgage and you are only charged interest on the difference between the two.

For example:

• Your mortgage balance is $300,000

• Your offset balance is $100,000

• Instead of being charged interest on $300,000, you are only charged interest on $200,000 – the difference between the loan amount and the offset balance.

With an offset account, the loan balance stays the same so the minimum repayments do too. It’s just that you’re charged less interest, so the loan balance goes down quicker as more of your repayment goes to the principal.

So, which is better?

There is no right or wrong here. There’s only what works for you, in your personal circumstances, at this point in your life.

Here’s some tips to consider to making this decision:

• If you don’t have a lump sum saved somewhere: you may prefer to forget the offset and concentrate on upping your regular repayment by a few bucks at a time (PS: you really should have a lump sum somewhere – a nice cushy buffer fund to cushion you through the inevitable shocks of life. Might be time to get started on that).

• If you do have a lump sum, consider these two questions:

  • Can I comfortably keep making my repayments?

    • If not, paying off a lump sum will help drop your repayments.

  • Do I think I might want to access this money again?

    • If yes, you may prefer an offset.

To help you get your head around what happens with the interest, I’ve worked up an example using this base case:

• $300,000 loan

• 7 per cent interest

• 30 year term

The minimum monthly repayment is $1,996.

I ran a few different scenarios:

• Method 1 - pay a little extra (switching to fortnightly repayments of $998)

• Method 2, Option A- Pay, $100,000 onto the loan, keep original fortnightly repayment of $998

• Method 2, Option B - Pay $100,000 onto the loan, switch to minimum monthly repayment of $1,331

• Method 3 - Put $100,000 in offset, keep fortnightly original repayment of $998.

Here’s how the interest charged changes over time for the various scenarios

Base Case - monthly minimum repayments, no offset or lump sum

Total interest charged over life of loan: $418,527

Method 1 - Pay a little extra, $998 per fortnight

Loan repaid by 23 years, 9 months (6.25 years quicker)

Total interest charged over life of loan: $315,094

Method 2A - Pay off lump sum into redraw, keep $998 fortnightly repayment

Loan repaid by 11 years, 3 months (19 years and 3 months quicker).

Total interest charged over life of loan: $88,337

Method 2B - Pay off lump sum, drop repayment to $1,331 a month

Loan repaid in 30 years (no time saving).

Total interest charged over life of loan: $279,018

Method 3 -Put lump sum into offset, keep $998 fortnightly repayment

Loan repaid in 15 years (15 years quicker)

Interest stops when offset = loan balance by 11 years, 3 months (19 years and 3 months quicker).

Total interest charged over life of loan: $88,337

Put them all together and this is how it looks:

Method 2A is invisible because the curve is identical to the Method 3 line - they overlap.

And here’s the key numbers in one spot:

As you can see, it doesn’t matter whether you pay off a lump sum or put it in an offset.

If you keep the repayments the same, you’ll pay the same amount of interest, and it will be less than the other options.

What are the risks with redraw?

When you make more than the required monthly repayments, you pay your mortgage off faster.

The difference between what you have paid and what you needed to pay is usually reported on your mortgage account and will often be treated as available cash. This is called your redraw.

I am occasionally asked whether an offset and redraw are effectively the same thing. After all, both are lumps of cash reducing your interest charges.

I simply get nervous if it’s in redraw.

When it’s already paid off the mortgage, it’s in the bank’s hands. If they decide they don’t want you to have what’s in redraw, you’re stuck. For example, if they reassess your loan and it falls into a different risk category – they could conceivably keep it.

For those crying ‘impossible!’ - it happened during COVID.

Because so many people use their home loan as their buffer fund, there’s a risk you’ll need the money in an emergency and not be able to get it.

When it’s in an offset, it’s treated the same as a savings account. It’s yours, not theirs. No permission needed to get access, though there may be minimum limits on how much you can take out at a time.

What are the risks with offset accounts?

Offset accounts are savings accounts.

They fall under the Financial Claims Scheme, which means that up to $250,000 is guaranteed by the government, per authorised deposit-taking institution (i.e. bank), per person.

So, for two people, you can have up to $500,000 covered at one bank.

We leave a big gap between the theoretical limit of $500,000 and our offset balance target so we aren’t caught out if the bank fails, which would mean anything over $500,000 isn’t covered by the guarantee. We’ve chosen $250,000 as our target as we have multiple other accounts with our lender. The balances fluctuate over time.

You may also find having an offset account means paying fees. Check with your lender.

Finally, offsets aren’t always possible against loans with fixed interest rates. Again, check with your lender, and remember it may be possible to fix part of your home loan while leaving the rest variable.

For FI folks: think about borrowing capacity

As work towards financial independence (FI), you may be dropping back your work for wages.

This has implications for your borrowing capacity, should you want to buy another property.

Our personal strategy is not to pay off the home loan early, even though our offset is generally full (i.e. we’re offsetting 95-100% of our mortgage at any given time). We treat that as a loan we can access if and when we decide we need to, by pulling cash out of the offset, bypassing the need to apply for a loan separately.

We have also prioritised offsetting our home’s mortgage ahead of investment property loans, as we’re not debt recycling and therefore our home’s interest is not tax deductible. It’s in our interest (ha!) to keep the mortgage balance higher on the investment property than our home.

Author’s note: this article was originally published on the Money School blog in November 2017 and has been refreshed in July 2024.

We’re slowly migrating the blog across to Beehiiv, which means we’re losing the comments on the original Wordpress blog.

Sorry to those who asked questions or made comments, you’re welcome to re-add them here.

Addressing common themes in those comments:

1. Different interest rates for loans with offsets versus redraw - I haven’t seen this with my lenders; the rate has been independent of whether there’s an offset account or not. Different rates have typically been for the type of property - home or investment - or whether it’s a fixed or variable loan. Consider shopping around for a lender that doesn’t charge more interest for having an offset account.

2. Offsetting versus investing elsewhere - if you’ve got a lump sum, a few people assert that you’re better off investing that money than leaving it against a loan. Perhaps - but the interest on the mortgage is guaranteed, the returns are not. You also have to account for any tax you’d pay on the investment. This is as much a sleep-well question as a maths one.

3. Security - concerns about scamming/hacking are valid and apply to all online bank accounts. Please note banks work hard to make sure they don’t get hacked, so it’s more often through the customer’s end that scamming occurs. Best practise is to not share your login with anyone, and to treat any unsolicited requests for personal information as potential hacking/phishing attempts.

About Money School

If you’re new here, welcome! Delighted to have you 😁

This is the blog for Money School, an Australian financial education company.

The main site is at https://www.moneyschool.org.au, but I keep our articles over here on beehiiv.

Everything on the main site and this blog is for educational purposes only. I’m not a financial adviser, nor do I play one on Netflix. I aim to help you learn about money so you can ‘choose your own adventure’.

Money School was co-founded in 2010 by me (Lacey Filipich) and my mother, Fran White. Money School offers workshops, online courses and have an international award-winning book, published with Penguin Life in 2020.

I’m also a regular media commentator on all things personal finance. If you’ve got 16 minutes to spare, you might like to check out my TEDx talk (over 1m views!) on financial independence and mini-retirements.