Home loan versus savings account interest: there is only one choice

Interest has soared on both mortgages and cash deposits, but there are big reasons why a home loan should be paid off first.

Balancing mortgages and savings is simpler than many may think. Picture: iStock

Surging interest rates over the past two years have delivered pleasure and pain to Australians, depending on where their wealth sits.

People with piles of cash in savings accounts have watched their deposit interest rates reach 5 per cent or more after a decade in the doldrums.

Meanwhile, those with mortgages have seen their repayments spiral more than 60 per cent higher as the Reserve Bank rapidly rose its official interest rate from 0.1 to 4.35 per cent. The rate rises have pushed many households into mortgage stress.

But what about people with both a big home loan and a savings account full of cash? Can they benefit from both?

Well, they can both earn and pay interest simultaneously, but that makes absolutely no sense financially. They might as well chuck money down the drain.

There are two key reasons for this being a bad idea. Firstly, mortgage interest rates are higher than savings account interest rates, so in gross terms people lose more than they gain. Why pay an average 6.6 per cent on a mortgage and earn just 5 per cent on a bank deposit?

Rising interest rates since May 2022 have sent mortgage stress soaring. Picture: iStock

Secondly, and most importantly, is the tax treatment of both – and the key reason why anyone with a mortgage shouldn’t stash much cash in a bank account.

Australia’s tax rules mean we pay income tax on our interest earnings. So for $10,000 sitting in a savings account paying $500 interest, people on a 32.5 per cent marginal tax rate (plus 2 per cent Medicare Levy) will lose $172.50 of it to the ATO, while people in the top tax bracket lose $235 – close to half.

However, if that $10,000 is paid off a home loan instead – or sits in a mortgage offset account or a loan with a redraw facility – the savings it generates are much larger.

We pay off mortgages with after-tax money, so typically 34.5, 39 or 47 per cent of our employment and other earnings are already gone in tax before we get a chance to pump the remaining cash into a home loan.

This means that every dollar you put into a mortgage rather than a savings account has a much more powerful financial impact. Double in many cases.

That’s not to say that people with home loans should not have an emergency source of funds, because financial surprises often pop up. For some, that will be cash, for others it may be a credit card with no debt.

Mortgage offset accounts and redraw facilities are arguably the best ways to get more bang for your buck. Directing all income into an offset account means every dollar you have is working harder – because it reduces the loan principal upon which mortgage interest is charged.

Redraw facilities allow people to withdraw previous extra repayments they have made on their mortgage, but this may take a day or two to process.

Always check with your lender about details and fees, but understand there are better options that holding a pile of cash – even if it may feel good to earn interest income.