Finance Battle #1: Home Deposit: P&I IP Offset VS HISA

Offset vs. HISA

From time to time it gets suggested to use an IP Offset over a HISA as you should chase what ever has the highest return.

However does the initial higher return work out in the long term?

Variables

• Marginal Tax Rate (%):
• IP Interest Rate (%):
• PPOR Interest Rate (%):
• HISA Rate (%):
• Cash ($):

Issue #1: Tax

Many are use to a PPOR offset being tax free. But its not so obvious that for an IP Offset we are indirectly taxed. If you put $10,000 into your IP Offset you are no longer paying about $630 interest, so you have $630 less to tax deduct. This increases how much tax you pay by your marginal tax rate x $630. And thus the offset is taxed.

Issue #2: Equity

Even less obvious is where the $630 ends up. Most offsets lock the 'saved' interest into the properties equity where it is unable to be extracted for a future PPOR purchase in a tax efficient manner. It is paying down the debt ahead of the payment schedule. And paying down tax deductible debt is not a great return.

Issue #3: Not Reversable

And this is where a few get caught out, you cannot undo this. You cannot pull the equity from the property and make it tax deductible when that money is used to buy your future PPOR. You need to sell to fix this mistake. 

Its the purpose not the security that determines if a loan is tax deductible.

Issue #4: Reduced Savings

And finally even less obvious is as the full 6.30% saved is locked in, the tax comes from your savings. So in fact your deposit is diminishing at around = Interest Rate x Marginal Tax Rate = 1.98% pa. So this approach certainly speeds up paying off the IP at the expense of your savings and future PPOR. 

The saving grace is you will have more equity in the IP that you could use to buy your PPOR but without the tax advantage.

Example

Lets assume you want to put $10,000 into either option. 5.50% HISA, 6.30% IP Mortgage.

5.50% HISA

1 Year Return After Tax

= $10,000 x (5.50% x (100% - 32%)) = $374

6.30% IP Offset

1 Year Savings After Tax

= $10,000 x (6.30% x (100% - 6.30%)) = $428

So at face value, IP Offset nets us a higher after tax return of $54 or about 0.54% pa.

Cashflow

Now the catch is the IP offset savings generally do not reduce the repayments. Thus the savings are stuck in the equity, and can no longer be used for a future PPOR in a tax efficient manner. On top of this, the full $630 is stuck there, meaning we need to find enough to cover the tax bill from our savings.

As an example, the $10,000 in our IP Offset reduced our interest bill by $630 over 1 year. That $630 is reflected by a smaller outstanding mortgage balance. 

Lets assume before using the offset our property was neutral from a tax point of view, so the total rental income minus costs = $0.

After putting $10,000 into the IP Offset it has reduced our costs by $630, so on our tax we now declare a net rental profit of $630. The ATO will then ask us to pay tax on that at our marginal tax rate, being = 32% x $630 = $202. So we have increased our tax bill, or reduced our refund, by $202, and that in turn reduces our savings by $202.

So from a cash flow point of view as the IP Offset is a negative return, the HISA nets us an extra:

HISA Cashflow

= HISA Return + Cash x IP Rate x MTR

= $374 + $10,000 x 6.30% x 32%

= $576

PPOR Payback

We can now put that cash towards a future PPOR which gives us a tax benefit being our Interest Rate x Marginal Tax Rate = 1.98% on the retained cash. The pay back years is then:

Pay Back Years

= (IP Return - HISA Return) / (HISA Cashflow x PPOR Rate x MTR)

= $54 / ($576 x 6.19% x 32%)

= 4.8 years

So after 4.8 years years break even by taking the lessor HISA return, and then its all gravey.

Alternatively we can see the benefit as HISA Cashflow Rate X Interest Rate x Tax Rate pa that it takes to pay off the PPOR

Yearly PPOR Benifit (%/pa)

= HISA Cashflow Rate X PPOR Interest Rate x Tax Rate

= 5.76% X 6.19% x 32%

= 0.11%

So pay a once off fee of 0.54% to then make a yearly improvement of 0.11%.

Multiple Years

Using the HISA over multiple years can be seen as independent decisions, where each year has a fixed cost (0.54%) to keep the cash on hand. Once we have the cash, it stays with us. We can then repeat the process for year 2 etc until we buy the PPOR. After say 5 years we will have retained 5 x 5.76% = 28.78% at the cost of 2.72%. 

This simplification is ignoring a small amount of compounding.

Summary

Using a HISA yields 0.54% less pa, but keeps 5.76% pa more cash for the future PPOR. When we buy the PPOR we then get a benefit of 0.11% pa until the PPOR is paid off.

Absolute Terms

But lets just remember how much money we are talking here. The loss we make initially on the HISA for $10,000 is $54 pa. If we then buy a PPOR, we are saving $11 pa.

So for small amounts, or short periods, go with which ever option you prefer.

Interest Only

If your IP Offset reduces repayments such as most IO loans then ignore what I've said above, and just use the offset. The rate is still crap, but at least you don't lose access to the cash.