using mortgage interest offset account to control gearing

3 Reasons To Use An Interest Offset Account

We have covered the various mortgage interest offset accounts last week.  This week let us look at what are some of the circumstances one would make use of such a feature.

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We have already explained that there is usually some kind of premium one has to pay for having an interest offset account; there is no free lunch in this world.  The bank would have built in the costs of providing such a feature in its loan spread.  Some will require that you take up a home loan package at much higher spread than if you do away with such a feature.  There is only one bank that seems to offer it strategically as a product bundling to all its floating rate home loan packages without any markup in its spread.  Read our earlier article to find out which bank.  Even so one still need to give up his consumer rights to choose the bank with the most competitive interest when refinancing, therein lies the “premium or opportunity costs” of selecting a mortgage with interest offset feature.

Why would someone want to pay a “premium” for interest offset feature?  I could think of 3 plausible scenarios:

1. Cash Is King (Especially During A Downturn)

The most obvious reason for an interest offset account is to keep all one’s cash in liquid manner which can be drawn upon when the opportunity arises.  Imagine John who lives with his family in a condo and has a cash of $800,000 on hand for investment and decides to buy a 2nd property which incidentally costs $800,000.  Imagine he draws a decent employment income that allows him to take the maximum loan of 50% for a 2nd mortgage.  Transaction costs aside, he will need to put down $400,000 of his own money and take a loan of $400,000.

He could easily pay in full cash $800,000 for the property but he chooses not to do so as interest today is still at a low of 1.50% p.a. for floating rate mortgages and he is waiting for the right time to invest into the stock market which he deems underweight.  He needs to hold on to the cash as no one knows when the next great recession will occur and when it does, market conditions might render it hard to get a term loan (on the property) of the same quantum as before as valuations may have dropped or job conditions might have changed.

To hold on to maximum cash while waiting, the best option is to choose a loan that comes with an interest offset feature of say up to 66.66%.   He would be servicing the mortgage interest on a loan of $400,000 but after parking his funds of up to 2/3 of the outstanding loan (where he is paid the same interest for deposits as his mortgage), he is essentially servicing mortgage interest of just one-third or on $133,333.  If he is financially savvy enough to park his last remaining $133,333 of his own money in an instrument that returns a stable yield of 3-5% p.a. like retail bonds or REITs (subject to asset price fluctuations), he is able to “hedge” the mortgage interest costs while waiting for the market to crash and assets go for a steal.

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There is also a group of people with cash holdings who wants to invest into the market but does not know exactly what to buy or when to buy yet.  They will need such flexibility or liquidity that comes with an interest offset account.   Then again there is another group of investors who have bought overseas property and taken up financing from foreign banks pegged to foreign base lending rates eg. Libor etc.  When interest rate creeps up later globally they want to have the flexibility to “draw down” on their own funds from an interest offset account to pay off mortgage that has the lowest base lending rates.

Indeed there can be many uses or deployment of one’s funds at the right time.  The bottom line is – an interest offset account provides liquidity as and when opportunity arises.  Cash is king especially in a depressed market.

2. Reduced Loan Capacity In Near Future

In the same example above John may have also sensed some headwinds in the industry he is operating and he gets an uneasy feeling about the stability of his job.  Maybe he has seen some of his colleagues being made redundant over time and were eventually retrenched.

Still he senses that buying a 2nd investment property quickly is important as asset prices have already softened from its high in Singapore two years ago.  Yes the market could go down another 10% but his own job might also go down before that happens and it is vital he gets the maximum loan while he still can with his current high income.  Getting the investment property early so that he gets a tenant to start paying down the mortgage for him with the rents he will be collecting is also the most viable way to build retirement nest egg.

In such a scenario, John would prefer to hold on to most of his cash (up to 50% of his $800,000) and max out his loan capacity on two mortgages (owner-occupied and investment property) before his financial position changes.

Others out there might not face industry headwinds in his company like John, but may decide to go for a career change soon for example, resulting similarly in a change in one’s financial position.

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3. Risks Of Investment Property

Buying a property comes with risk.  The housing oversupply situation in Singapore leading to a drop of at least 10% in rents over the last two years is already well documented, and it is set to get worst in the next few years.  The risk of holding on to an empty property with no rental income in between tenants is becoming real, especially when the property gets older (tenants tend to prefer newer buildings).

Another benefit of an interest offset account is that it allows one to vary and control the amount of leverage at different times.  In the case of John who has now successfully bought his investment property of $800,000 taking on a mortgage of $400,000 with an interest offset feature, he is essentially paying interests only on $133,333 as explained, while trying to rent out his new property to the right tenant at the right price.  Once the lease is signed and he starts collecting a decent rental cashflow, he is free to deploy more leverage now as the rent is sufficient to cover the higher mortgage repayment when he draws down on his own funds.  When the tenant leaves at the end of the lease, he could ready himself to divest out of his investments and bring his leverage down once more by parking his funds back to the interest offset account.  Such scalability of leverage without the need to go back to the bank to apply for a bigger loan as one ages is another beauty of a mortgage interest offset account.

So is an interest offset account useful and worth paying the premium for?  You be the judge.

At MortgageWise, we seek to be your mortgage solutions partner and take pride in being able to give truly independent advice sometimes asking clients to re-price and stay with their existing bank if it doesn’t make sense for them to move. We may not get to do business with you the first time round, but we will try again. We strive to be your first choice mortgage partner in Singapore when you buy your next property. Meanwhile do sign up for our newsletter on our website and stay tuned to this blog as we bring you purposeful and proprietary news summary & insights.

 

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About Darren Goh

Darren Goh is the Executive Director of MortgageWise.sg, a thought leader in the Singapore mortgage industry, with frequent interviews and quotes by the press - Business Times, Straits Times, Zaobao and EdgeProperty for his views on the latest mortgage trends. He is an avid property investor with careers in banking & real estate before becoming an entrepreneur.
View all posts by Darren Goh

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