At some point in evolutionary history, offset accounts became the new black, redraw was all the rage and trend spotters questioned whether lines of credit were fashion or fad.
Increasing competition in the banking sector, which began with the arrival of non-bank lenders in the mid 1990s, has engendered a culture of constant product differentiation between mortgage providers.
But before you rush headlong into your broker’s office demanding an offset account be hooked into your loan, make sure you consider all the factors at play. Do you really know what these features are for? Will you really use it?
A new era
You save for a deposit, find the home of your dreams and then take out a mortgage to fund the balance. The bank asks you to pay down your loan in equal monthly instalments for 25 years. That’s it, right?
For better or worse, managing your mortgage has become a remarkably complex exercise – but while there are more options from which to select every step of the way, there are also more opportunities to save some pennies if you structure your finances correctly.
Today’s loan features have come a long way since they were first introduced. Partial offset has become 100% offset and redraw is nearly stock standard on most variable loans, to name a few. Features were designed with two benefits in mind – improved flexibility and accelerating the speed at which the mortgage is paid off.
In deciding whether or not loan features such as early repayment, redraw, offset or a line of credit are really for you, like any financial planning exercise you need to go back to basics and ask yourself what your overall strategy is for your mortgage. This can vary immensely from person to person – some people are just trying to rid themselves of debt using the fastest means available while others are using their home loan as a launch pad for other investment opportunities.
A key requirement for any loan feature, besides asking yourself whether you would actually use the facility, is this: “Do I have enough financial discipline to make this strategy work? If the answer is yes, good, if the answer is no, go for a standard or basic variable loan with the cheapest possible interest rate you can find,” says Steve Sampson, general manager of Mosaic Financial Services.
Redraw and early repayment
Redraw and early repayment are roughly akin to power steering and air conditioning in new cars – they were first released only in luxury cars with all the flash bang features but over time have found their way into the base models of most brands.
How does it work?
The actual mechanics of redraw and early repayment are fairly straightforward: early repayment allows you to pay off your loan in lump sums greater than your designated minimum balance while redraw allows you to withdraw any extra funds you have deposited.
Why would you want to deposit additional funds into your home loan account, only to realise you actually need those funds at a later point? As Sampson explains, these features offer you an ideal means of using your savings to pay your home loan off faster, while still being able to enjoy the fruits of your labour.
“You might be saving for a holiday, and instead of putting that in your savings account you put it in your redraw account and then draw it out later, which reduces your tax. If you put your money in a savings account you’ll get taxed on the interest that you earn on that account. If you put the money in your home loan it just reduces the debt, and you reduce the interest that you have to pay,” he says.
Who can benefit?
Sampson extends the suitability of redraw facilities to self-employed borrowers who are registered for GST. “Self-employed people who are accruing their tax can use redraw to partially offset their home loan debt. Redraw would be a good idea in circumstances such as if you are able to put the savings from your Business Activity Statement (BAS), which you eventually pay the tax office.”
For those with tightly balanced budgets who have very little cash to spare, redraw is probably not a useful facility, according to Sampson. “If you’re repaying a fairly high percentage of your salary to meet the minimum criteria of the loan, you’ve got to wonder why you would need a redraw. Sometimes a redraw can add up to 0.5% to the interest rate. So you need to work out whether having the redraw is worth paying that premium.”
What is the cost?
With the majority of lenders charging a fee for excessive redraw transactions or at least imposing a minimum balance on the amount withdrawn, it pays to plan your expenditure well ahead of time if you want to minimise the costs. Redraw is by no means a free lunch for the consumer, and it is essential that you balance the relative cost of using the facility against any fees your lender may impose.
The question you should ask of your broker or lender is not ‘does my loan have early repayment or redraw?’ but ‘will I be charged extra for these features?’ An exception to this is fixed rate loans, wherein you are often prevented from paying anything over your minimum balance, although lenders are becoming more flexible in this regard.
“Establish the cost to you of having a redraw,” says Sampson. “Work out the accessibility to those funds that you will require. How much extra interest am I paying? What is the fee for redrawing as against if I put this spare money in a savings account, how much would I earn, less the tax I would pay on the interest I accrue? Is there a fee on the interest rate? Is there a fee for redrawing?”
Line of credit
If ever there were a Pandora’s box in mortgages, it would take the form of a line of credit. In its most basic sense, a line of credit is an interest only revolving facility secured against the equity in your home. While technically a standalone mortgage – otherwise known as a home equity loan – where lines of credit, are used as a day-to-day financial management tool, they operate in much the same way as features such as offset and redraw.
How does it work?
In its most basic sense, a line of credit refers to a portion of your home loan – either a fixed amount such as $100,000 or a percentage of the total – and these funds effectively sit there and are at your disposal. These accounts operate similarly to revolving lines of credit used by business borrowers.
Imagine your LOC limit is $100,000. Initially, the account would have a zero balance, which becomes negative each time you draw funds from it. Conversely, if you elect to have your salary deposited into the LOC, the balance would be positive. You start paying interest on your LOC the minute that the balance falls into negative territory.
The most effective way to use a line of credit to reduce your mortgage is to have your salary deposited into the account at the beginning of the month so it is reducing the total balance of the loan for a short time. Instead of using your salary to meet your monthly expenses, put these on your credit card instead. Use next month’s salary to repay your credit card in full – and you will have reduced your interest bill.
Who can benefit?
A general prerequisite for those considering their suitability to a line of credit is having enough equity in your home through which to fund the facility. Although no hard and fast rules apply, Dan Heylbut, business development manager at Australian Finance Group, says that “personally, I’d want to have at least 20% equity built up in my home before taking out a line of credit.”
There are two inherent problems with LOC loans, which can be avoided if sufficient thought is given in the first instance to how it will be used. Firstly, these loans are interest only, so by definition you will not be building any equity in your property simply by meeting the repayments.
More importantly, LOCs can pave the way to financial headache if you do not exercise discipline. Although fewer people are seeing LOCs as a means of using their equity to buy whatever they like, without careful management they can end up increasing your mortgage rather than helping to reduce it, as Sampson explains:
“Lines of credit are mainly used for, provided you have the discipline, reducing your mortgage quickly and also to fund other lifestyle purchases. That’s where a line of credit can be dangerous in the wrong hands. I think of the people who take out lines of credit to reduce their home loan more quickly, 80% don’t end up being successful.
“The minimum payment on the line of credit is the interest. If they start spending a bit of extra money elsewhere, they’ve only got to repay the interest on a line of credit whereas on a normal loan you must repay principal plus interest,” he says.
What is the cost?
Whether lines of credit offer value for money is open to debate, with some experts claiming that lenders charge higher rates for these accounts than their variable rates. Others argue that LOC rates have reduced significantly as a result of competition in recent years and are now approaching that of standard variable home loans.
With some lenders simply charging an annual fee for an LOC, it can be difficult to compare products. This is especially tricky for those who have trouble forecasting their upcoming expenditure in detail. To work out whether an LOC is for you, it is essential that you firstly find out what you will use it for, and for how long the balance is likely to be negative.
In a similar vein to lines of credit, offset accounts were developed to help people pay down their mortgages more rapidly. Whilst the mechanism of offset accounts is roughly similar to that of a line of credit, two important differences exist.
How does it work?
Firstly, unlike LOCs, offset accounts only allow you to withdraw that which you have deposited into your home loan over and above your minimum payment.
Secondly, offset accounts allow you a benefit not currently available to those on a line of credit – you actually earn interest on funds deposited into your offset account, which sits alongside your home loan with a credit rather than a debit balance. There are two types of offsets – partial and 100%.
Partial offsets are essentially an early form of the offset concept – whereas you are probably paying in excess of 7% on your home loan, a partial offset account would permit you to earn a lesser amount in interest on your credit balance. 100% offsets on the other hand allow you to earn exactly the same interest rate on your savings in the offset account that you are paying on your home loan.
Who can benefit?
Like lines of credit, offset accounts are most beneficial to those who can exercise financial discipline. “The offset can be like your everyday trading account, for your ATM transactions, Bpay and all those other bills and then you would put any money remaining at the end of your bill cycle and put it into your home loan. Should you ever require it, you can draw it back,” says Heylbut.
What is the cost?
Like all good things in life, the privilege of offsetting your savings against your home loan balance does come at a small cost. “Some lenders charge a monthly fee for offset, and some don’t charge at all. The premise of offset is that you’re going to have at least some funds in there reducing the balance of your home loan. From a lender’s perspective, this is on balance, less risky,” says Heylbut.
Offsets therefore represent an ideal place to park some of your savings and have it actively reduce your interest bill. Unlike early repayment and lines of credit, you are also earning tax-free interest at the same time. It’s a concept that’s ideal for Australians, who are notoriously bad at putting money aside, says Heylbut.
“As Australians, we’re not very good savers. We’re good re-payers, just not very good savers,” he jokes.
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