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Offset mortgages

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Written by Marianne Curphey

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. The cash savings in this account are then 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 slash the amount of interest you pay and/or help you pay off your mortgage early. But they’re not for everybody.

As a general rule, offset mortgages are best suited to 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 some of the capital on your home loan. This is how it differs from an  interest-only mortgage, with which you just pay off the interest each month - and repay the initial amount borrowed as a lump sum at the end of the term.

At the start of your repayment mortgage journey, most of your monthly payments 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, which must be held in a linked account offered by the same bank or building society.  Having your savings in a so-called offset account means that rather than earning interest, they’ll be set against your outstanding loan and you end up paying less interest.

Say, for example, you have a £200,000 mortgage and £50,000 in savings. With an offset mortgage, your £50,000 linked savings will be used to reduce your mortgage by the same amount, meaning the amount you owe is counted as £150,000. 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 on your mortgage, meaning you can pay it off sooner and more cheaply.

What does overpaying on a mortgage mean?

Overpaying on your mortgage means you are paying more than the amount set out in your contract. Most mortgages allow you to overpay by up to 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) that you don’t need immediate access to but might do in the future, an offset mortgage could work well for you. 

One of the biggest advantages of an offset mortgage is that, if you do need access to your offset savings in the future, you’ll be able to withdraw them without charge or having to arrange a new loan. 

But beware: you’ll need to be pretty self-disciplined with your money because, although you have 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 best offset mortgage rates are often slightly higher than those on regular mortgages.

So 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.

There are also savings income tax considerations to take into account. The Personal Savings Allowance (PSA) allows higher rate taxpayers to earn the first £500 from their savings tax -free. But 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 even 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 June 2020, the top two-year fixed rate mortgage with a 75% LTV and 25-year term has an interest rate of 1.17%. The top offset mortgage with the same terms is at around 1.36%.

So as you can see, while offset mortgage rates are higher than traditional mortgages, there is not always a big difference. In the past, there was only a limited number of offset products available on the market. They were usually aimed at people who wanted to 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), offset mortgages have become a more attractive option. 

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 interest rates on offset mortgages are often higher than traditional mortgages is that you’re paying for the added flexibility it offers. So 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 to get the best deal overall. 

What are the pros and cons of offset mortgages?

Pros

  • 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. 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.

Cons

  • The interest rates are slightly 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 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 standard repayment or interest only 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 will be earning by reducing the interest you pay on your mortgage. 

As those returns are also tax free, offset is a good option for anyone who does not get the PSA or whose savings income exceeds the limit for their tax band (£1,000 a year for basic rate taxpayers and £500 a year for higher rate taxpayers).

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 by more than the traditional 10% a month allowance.

As we’ve mentioned above, added flexibility means the interest rate might be slightly higher than the cheapest mortgage deals, but it could also help you reduce the overall mortgage term and be debt free sooner. 

Remember though, if you overpay on a traditional mortgage, you won’t be able to access those funds again. It is also vital to talk to your mortgage lender to find out if they allow you to overpay first. Otherwise, you could end up facing hefty early repayment charges or penalties. 

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