Most of banks offer many features with their loan products these days and figuring out which option(s) work best under your specific circumstance could be a daunting task.
I have had many people asking me whether they should choose Redraw or Offset facility when buying their home and especially if they want to turn it into an investment property later on.
Redraw is a basic feature that comes with the entry level products from almost all lenders whereas the offset feature will cost you either a monthly account fee or a yearly fee depending on the lender.
Let us look at the two scenarios separately and their tax implications.
Purchase your home with a Redraw facility
As redraw facility is considered actual loan, an issue can arise for the purpose of tax deductibility. By placing additional funds into the loan via redraw, you are effectively reducing the loan balance and therefore permanently reducing the interest that can be claimed on the loan.
Once any part of the principle loan is paid back to the lender, and later on you decide to draw down more money against the equity of the property, with the intention of using those funds for investment purposes, this will be treated as new borrowings and only part of this interest ‘might’ be considered as tax deductible.
Thirdly, this will also create a logistical nightmare for your accountant, especially if there were multiple transactions involved. In some cases, the ATO might consider the entire interest component as non-tax deductible.
Purchase your home with an Offset facility
An offset account is a completely separate account from the loan, and merely linked to the loan, so depositing funds into a 100% offset account does not change the balance of the actual loan.
Let us now look at an example:
In the scenario below, both John and James are buying their home with the intention of later changing the status of the property to an investment property. In both cases, the property is $500,000 and both John and James have 20% deposit ($100,000)
- John uses the entire $100,000 as a deposit and he saves money from lenders mortgage insurance (LMI) as he only borrows 80%. John also has the redraw facility.
- James only pays a 5% deposit ($25,000) and he places the reminder of the deposit ($75,000) into an offset account.
The structure James chose give him the following significant advantages over the structure set up by John:
- James has access to $75,000 in cash, so he is always market ready to buy an investment property should one become available. In comparison, John would need to re-finance his property in order to set up a redraw facility subject to lender approval.
- James has access to $75,000 in cash that can also be used for other purposes such as renovation, investing in shares or other personal use (not recommended). It also gives him a buffer in case of emergencies or unforeseen circumstances.
- Because James’ offset account ($75,000) is completely separate from the loan ($475,000), this ultimately means that depositing and withdrawing excess funds in and out of the offset account has no bearing on the tax deductibility of the loan interest associated with that property if you change its status to an investment property late on.