The  subject of a mortgage offset tax deduction probably won’t come up at many parties you attend.

But it surprisingly DID come up at a recent social function I was at. We somehow got onto the topic of which bank people had their mortgage with and what rates they were paying.

After asking the group if they had offset accounts, it became apparent that only one of them knew exactly what I was talking about.

I then asked if there was anybody looking to buy another property in the future and keep the one they were living in as an investment – a few heads nodded.

The mortgage offset tax deduction is a poorly understood strategy that can benefit you in this situation. It’s best illustrated with a couple of working examples of how setting them up correctly when you buy your first property can provide much better options down the track…

Meet Bill and Jill

Bill and Jill are in their late 20s and are looking at buying their first home. They plan to borrow $500,000 mortgage from the bank. They each earn $90k+ per annum and their goal is to pay down the mortgage ASAP.

Scenario 1: Traditional mortgage

  • Go to the bank and borrow $500,000 as a traditional principle and interest mortgage with the ability to make additional voluntary repayments.
  • Pay the mortgage off as quickly as possible and, in seven short years, they will own this property outright.

Scenario 2: Interest only (or principle & interest) mortgage with full offset account

  • Borrow the $500,000 from the bank with the facility for an offset account also available
  • All surplus funds and additional repayments are deposited into the offset account, and this acts as their everyday account.

The only difference between these two options is that, in the second one, there is still a mortgage against the home and a big lump of money offsetting the mortgage, in turn paying the same amount of interest as in the first scenario.

Seven years later…

Bill and Jill are now in their mid-30s, with their second kid on the way. It’s time to get some more space to live in.

After reducing the mortgage on the home entirely, they have either plenty of equity (scenario 1) or a big deposit (scenario 2) to buy and re-mortgage a new family home.

They keep the first home as an investment property rather than selling it. They now own two properties and their portfolio is going according to plan.

Let’s analyse each scenario after the purchase of the second property (for $950,000):

Scenario 1: Traditional mortgage

  • Borrow the full $950,000 for the new home, with a $700,000 mortgage against the new home, and the remaining $250,000 investment mortgage leveraged against the old home
  • With the old home now as an investment property rented out paying income, they cannot claim any of the interest costs on the $25,000 as a tax deduction (due to the fact that the purpose of the $250,000 loan was to pay for the new home, which is their main residence)
  • The $700,000 home mortgage is private debt and interest costs cannot be claimed

Scenario 2: Interest only (or principle & interest) mortgage with full offset account

  • Use the $500,000 surplus cash in the initial offset account as a deposit for the new home and get a new mortgage for the remaining $450,000
  • The mortgage on the first home remains intact at $500,000 and now there is no longer any surplus cash offsetting the interest, all interest costs will be tax deductible as the unit is now an investment property
  • The $500,000 new home mortgage is private debt and interest costs cannot be claimed

Doing the maths on mortgage offset tax deduction

Scenario one gives no ability to claim interest costs as a tax deduction. Scenario two allows interest to be deductible on the $500,000 mortgage linked to the original debt against the first home, as the mortgage was originally used to buy that first home and has never been paid down (only offset to lower the interest cost).

Let’s say interest paid is $20,000 per annum whilst an investment.

Assuming Bill and Jill are still on a wage and salary and are paying a maximum of around 33 percent on the top end of their income, this deduction of interest is worth up to $6,600 less tax (or more tax refund) every year.

Remember, under the two options, there is no difference in the interest charges or overall debt position.

The key benefit of a mortgage offset in these scenarios is less tax being paid in the long run.

Therefore, if you or any of your family or friends are buying your first home any time soon, get the best advice now – not later. By doing so, your tax savings may be significant.