There’s a great Albert Einstein quote that goes: “He [or she] who understands compound interest earns it… he [or she] who doesn’t… pays it.” It was the follow-up to his declaration that compound interest is the eighth wonder of the world.
Big call, right? But I’ll venture that one realisation can change the course of your life.
And I reckon, were Einstein alive today, the physicist would add to his much-overshadowed Theory of Relative Wealth: “The fastest, easiest way to stop paying compound interest is the Australian-invented mortgage offset account.”
Okay, maybe not, but the humble Aussie offset is my No. 1 debt-busting wonder. Let me prove it.
An offset account is quite simply a savings account hooked to your mortgage balance. Whatever money you have in it is netted off what you owe so if you have a $350,000 loan but $50,000 in the linked offset, you pay interest only on $300,000.
It basically means free overpayments. Any dollar you’ve squirreled away and every cent that passes through your hands reduces your mortgage interest and brings your debt-freedom date forward by years. Think savings for holidays, renovations, anything else… your six-months-of-salary Holy Sh*t fund (like how I assume you have one?)… even house your salary itself in an offset and live off a credit card until the bill is due (which you should naturally pay in full).
Just by doing the latter, my calculations show that on the average $350,000 mortgage at the average $77,000-a-year salary you’d save more than $10,000 and get out of debt nearly a year early (based on the discounted big-bank variable rate of 4.68 per cent).
You’d effectively leave just under $5000 sitting on your mortgage always. Saving for a $20,000 holiday in five years? By stashing $333 a month into your offset, then withdrawing it all on departure day, you’d get a welcome-home present of more than $6000 of saved interest – and mortgage-freedom six months early. And if you, happily, had the above $50,000 cash for the life of your loan, you’d save a whopping $90,000 and six years. You could possibly slash even more than these few examples deliver (hello, school fees!).
Instead, I repeatedly see people make two massive mortgage mistakes. The first is saving into a bog-standard savings account rather than offset. You’ll always come out behind because home loan rates are higher – typically 1 percentage point – and what you “earn” on the mortgage is tax-free. A deposit of $50,000 at today’s paltry best 3.6 per cent rate will net you just $49,000 versus our $90,000 from before – and you could hand over half to the ATO!
The second big bottom-line blunder is people sticking money in, rather than alongside in an offset, their mortgage.
Now Einstein, I’m sure, would want me to explain that this is mathematically the same; equal interest is saved. But with an offset you retain full flexibility to withdraw money how and when you want – without fees – and full tax deductions.
That last bit’s vital if there’s even a chance you’ll later turn your home into an investment property; you can only claim interest on your lowest-ever loan balance. An offset keeps your money quarantined from both your bank and the Tax Office. And you can get at your cash in the event of emergency, the entire point of getting ahead in life.
The devil in the offset detail
Here are three questions to ask your lender before signing on the dotted line.
1. Is it a full offset account, offsetting 100 per cent of your savings against your loan?
2. Does it offset at the same interest rate as the home loan? Fixed rate products are the most likely to save you, say, only half the mortgage rate.
3. Is an offset mortgage as cheap as any other one? There’s been recent sport in splitting out the mortgage-with-offset product and hiking its interest rate. Paying over the odds could wipe out your savings.