The difference between offset and Redraw - Mortgage loans that are right for you

With the recent uproar over ME Banks announcement that they were preventing, to various degrees, some customers access to their available redraw funds, it might be an appropriate time to outline the differences between funds kept in Redraw and funds kept in an Offset account.  

Firstly a quick recap; In the typical home loan with Principle and Interest payments, you know that if you only ever make the minimum payment each month, then that loan will be paid out down to zero at the end of the specified term.  If interest rates don’t change throughout this period, then your minimum monthly payment won’t change either.  This monthly payment combines a portion to pay the interest due, and a portion towards paying down the principle. 

Over the course of the loan, even though the total monthly payment may not change, the ratio of interest portion to principle portion will change.  At the beginning of the loan, most of the monthly payment goes towards paying the monthly interest and only a small amount goes towards paying down principle, whereas at the end of the life of the loan this is reversed, with the majority going towards principle reduction, and a small amount paying accumulated interest.  This is why, when you look at your home loan statement at the beginning of the loan, it seems that very little progress is being made on reducing the balance.

So if you can reduce this interest bill each month, then more of your loan payment can go towards paying down the principle. 
Paying more than the required minimum, either regularly or as a lump sum can help do this.  Even small regular payments over time can help make significant savings.  These extra contributions can be made in two ways, as extra payments directly into the home loan account to physically reduce the loan balance, or as deposits into an Offset account that is linked to the home loan. 

In the case of payments directly to the loan account, the effect is obvious.  As interest is calculated on the outstanding loan balance, then the lower the balance the less the interest.  In the case of an Offset account arrangement it’s slightly different.  If the home loan account shows physical balance owing of say $500,000, but a linked Offset account has a credit balance of $40,000, then for the purposes of calculating interest, the figure is calculated as if the loan balance was $460,000.

In both cases, you can still access these extra payments.  At first glance they appear to be two different ways to achieve the same overall effect, and in the basic mechanics of it they are.  In general, the differences come down to pricing, typically the Banks will charge a premium somewhere for the Offset account option. 

Maybe a higher interest rate on the home loan, maybe a monthly or yearly ongoing fee, it pays to check the details.  The Offset account options also keeps a clear distinction between the use of funds, you can in this instance, mix ‘investment’ home loan funds, with ‘owner occupied’ Offset account funds, and not cause issues come Tax time. 

Whichever option you choose will depend on your personal situation, and medium to long term goals.  Note that the above applies to variable rate home loans.  The majority of Fixed Rate home loans don’t offer this, or if they do, they come with operating restrictions.  Ultimately a good conversation in the beginning will help to choose the best option that works for you.