Not all mortgages are created equal. Beyond interest-only and repayment, fixed and variable rates, there are additional choices to be made. One option is an offset mortgage.
What is an offset mortgage?
An offset mortgage links the account in which you keep your savings to your mortgage with the same lender. Your cash savings are used to reduce, or “offset”, the size of the outstanding home loan on which you’re paying interest.
When used correctly, offset mortgages can help you lower the interest you’re paying or help you pay off your mortgage early, but they’re not for everybody.
They’re generally best for people who are higher rate taxpayers, are self-employed, have large amounts in savings, or receive much of their income in lump sums.
The higher the credit balance in your current or savings account, the lower your debt, as the credit offsets the debt and you only pay interest on the difference.
How does an offset mortgage work?
With a traditional repayment mortgage, your monthly payment goes towards paying off some of the interest and capital on your home loan. Of course interest-only mortgages just require you to pay off the interest.
At the start of your mortgage journey, most of your repayments will go towards paying off the interest, but as you gradually start to reduce the capital you owe, more will go towards paying off the actual debt. Any savings you have are kept separate and may or may not earn interest depending on what kind of account you have.
An offset mortgage works differently because of the affiliation with your savings. Firstly, your mortgage and savings will be held by the same lender. Secondly, having your savings in an offset account means that rather than earning interest, they’ll be set against your outstanding loan and you end up paying less interest.
For example, you have a £200,000 mortgage and £50,000 in savings. With an offset mortgage, your £50,000 linked savings reduce your mortgage by the same amount, meaning your debt goes down to £150,000 (£200,000 less £50,000). As your monthly payments are usually worked out on the whole of your debt (£200,000), you’ll basically be paying less interest and overpaying your mortgage, meaning you could pay it off sooner.
What does overpaying mean?
Overpaying your mortgage means you are paying more than the amount set out in your contract. Most mortgage products allow you to overpay by 10% each month – any more than that and you’ll be penalised.
However, with an offset mortgage, because your savings reduce your overall mortgage debt and therefore your interest, your repayments cut into the loan and help shorten the mortgage term – exactly what penalty-free mortgage overpayments would do.
Should I get an offset mortgage?
As we’ve already said, offset mortgages aren’t for everyone.
If you’re a basic taxpayer with a regular salary and limited savings, a traditional repayment mortgage could be a better fit for you.
Conversely, if you’re a higher rate taxpayer and/or have substantial savings (on top of your deposit) which you don’t need immediate access to but might do in the future, an offset mortgage could work well for you. The Personal Savings Allowance (PSA) allows higher rate taxpayers to earn the first £500 from their savings tax-free.
You’ll need to be pretty self-disciplined with your money because although you’ve the flexibility to dip into your savings, doing so will somewhat curtail the benefits of having an offset mortgage in the first place. This is because the interest rates usually aren’t as competitive as those on regular mortgages.
If you think you’ll need access to this money in the future, you’ll be able to withdraw it without charge or having to arrange a new loan. If not, you might be better off putting your savings towards a bigger deposit and sticking with a traditional mortgage with a lower loan-to-value (LTV). As a general rule, the lower the LTV, the better the interest rate.
If you are an additional rate taxpayer (that is, if your taxable income is over £150,000), then you’re not eligible for a PSA and the offset option may be more favourable for you.
“Whether this type of mortgage suits you depends on how disciplined you are,” says financial expert Warren Shute. “It’s a bit like diet and nutrition – you know whether you are good with food and eat sensible portions, or if you find it hard to resist temptation.
“It’s the same with money – if you know you are not good with money then don’t allow yourself access to an offset mortgage. You’ve got to protect yourself from your own behaviour. On the other hand, it can be a useful financial tool for the right people.”
How do offset mortgages rates compare to traditional mortgages?
As of December 2018, the top two-year fixed rate mortgage with a 75% LTV and 25-year term is 1.44%. The top offset mortgage is around 1.85%.
Generally speaking, offset mortgage rates are higher than traditional mortgages but as you can see here, not by much.
In the past, there were a limited number of offset products available on the market. They were usually aimed at people who wanted withdraw extra money from time to time, and to reduce their credit balance when they received bonuses or lump sums.
But with interest rates so low (both on savings and mortgages themselves) and the introduction of the PSA, offset mortgages have been somewhat opened up to a larger pool of people.
Senior mortgage manager at mortgage broker John Charcol, Ray Boulger, says: “The difference between offset and traditional mortgage interest rates is rarely more than 20 basis points (0.2 percent) higher than traditional mortgages, so for some people it can be really worthwhile.
“They might be suitable for people who have a volatile cash flow, like the self-employed. If you are putting aside money in a deposit account to pay a tax bill, for example, you could accumulate that and pay it when necessary. You know the money is there if your income is likely to fluctuate, and if you want to borrow more money you don’t have to ask for a further advance.”
The main reason why interest rates on offset mortgages are higher than traditional mortgages is that you’re paying for the added flexibility it offers. When deciding on whether or not to apply for an offset mortgage, you need to be sure you’re going to make the most of it.
Otherwise, the higher interest rates charged by offset mortgages reduce the potential benefits, which are mainly the tax advantages and the option to reduce the length of your mortgage term.
What are the pros and cons of offset mortgages?
- You could pay your mortgage off early. Lee Rhodes, founder and partner of mortgage advice specialist Rhodes Advisory Services says: “It is good to be able to pay off your mortgage – that’s a great asset to have behind you.”
- Flexibility at a low cost. Rhodes says: “Across the market offset rates are generally slightly higher than standard mortgages but there’s not a huge difference. If you are paying 3% on your mortgage and only getting 1.5% on your savings then why wouldn’t you offset?”
- Tax advantages. If you’re a high or additional rate taxpayer, you’ll most likely need to pay tax on your savings (higher rate payers only get £500 tax-free and additional taxpayers none at all). But with your savings in an offset account, your mortgage rate basically gets you the equivalent of a saving account’s return without the need to pay tax.
- The interest rates are higher. Plus, there’s the temptation to dip into your savings because doing so is penalty-free. Unless you’re confident you can leave your savings untouched and therefore reap the full benefits of lowering your overall mortgage debt, an offset might not be right for you.
- It’s only good if you’re in it for the long-term. You’ll need to stick with an offset mortgage for the majority of your mortgage term in order to pay it off sooner or significantly lower your monthly repayments.
- You can’t always get to all your savings if you need them. Some lenders have a minimum balance that you need to keep in your savings account.
- Limited choice. Fewer lenders offer these products, so you won’t have as much choice as with traditional mortgages.
What happens to your savings with an offset account?
Not a lot! Yet it’s important to remember that whilst you won’t receive any interest on your savings with an offset mortgage, you won’t need to pay tax on it either. This is one of the reasons they were popular with higher rate taxpayers.
But since the government introduced the new PSA in April 2016, most have tax-free savings anyway.
Alternatives to offset mortgages
Instead of keeping your savings aside to offset your mortgage, you could get a mortgage product that allows you to overpay (more than the traditional 10% allowance).
As we’ve mentioned above, added flexibility means the interest rate might be slightly higher than the market’s cheapest, but it could mean you reduce the overall mortgage term and be debt-free sooner. Remember, if you overpay on a traditional mortgage, you won’t be able to access those funds again. If you need to, it’ll most likely cost you. Talk to your existing provider to find out if they allow you to overpay – many do, but some only credit the overpayment at the end of the month, or even at the end of the year, rather than reducing the debt immediately.
It’s paramount you check with your lender if they offer this facility or not. If they don’t (or if your overpayments are restricted) you’ll end up with a hefty overpayment charge.
Now read our guide on how to pay off your mortgage early
Edited by: Sarah Guershon