Offset mortgages explained
Offset mortgages are a relatively new concept and allow you to use your savings to offset your mortgage balance.
This means instead of receiving interest on the savings held in the offset account, you don't pay interest on the equivalent part of your mortgage.
There are several benefits to this arrangement; firstly you will reduce the term of your mortgage if it is on a repayment basis as the capital portion of your payments will increase.
This has the knock-on effect of increasing the capital portion of all subsequent payments too which further compounds the effect.
If you have an interest-only mortgage it is typical for lenders to use the surplus in your monthly payment to reduce the mortgage balance which again has the same compounding effect of further increasing the surplus in each subsequent payment.
Some lenders may offer you the option to reduce your monthly payment instead often on an annual basis with your mortgage statement.
If you use the offset account as a current account it can offer even greater benefit, particularly in the current market where current account interest rates are generally poor.
Simply by having your pay paid into the account, you will clear your mortgage off early as even offsetting a few thousand pounds a month will still reduce the balance if the interest is calculated daily.
As well as compounding interest, there is another notable benefit which is most significant for those paying basic rate and especially for higher-rate taxpayers.
All interest payments from savings accounts which are not ISA's or TESSA's will usually be liable to income tax at your highest rate, often payments are made net of tax at 20% with a further 20% to 30% potentially being liable to tax for higher-rate earners.
In an offset arrangement taxation is avoided, as you cease paying interest on the equivalent mortgage balance rather than receiving interest on the savings.
This means for a basic-rate taxpayer that a savings account would need to pay an extra 20% more interest than the mortgage rate to be more profitable, however for higher-rate taxpayers a savings account may need to pay double the interest rate of the mortgage to outperform an offset based on current taxation policy.
If you were paying 3% interest on your mortgage you would need a gross interest rate of 6% on your savings to outperform the offset account for a higher rate taxpayer.
If the savings account calculated interest every month and the mortgage daily then it would lag even further behind.
It is important when comparing an offset mortgage to also consider the difference between the offset interest rate which is available and that of standard mortgage products as well as the difference between the offset and savings accounts.
If you don't consider this aspect fully, you could pay more for an offset facility than it ultimately saves you, and this is their biggest pitfall.
Working out whether an offset mortgage product is right for you is something we can help you with.
The other primary benefit over simply paying the extra sum off the mortgage is that the savings remain readily available for a rainy day, rather than being locked into your property.
The pros and cons of offsetting a mortgage
- Can help to repay your mortgage early and reduce interest paid
- May perform better than savings products
- Tax-efficient savings for higher-rate taxpayers particularly those already using ISA allowances
- Can be used to effectively pay a lump sum off the mortgage without tying sums into the property long term
- Often come with other flexible payment features such as underpayments or no early repayment charges
- Typically have a higher interest rate than standard mortgage products
- Usually have higher arrangement costs
- Complicated to compare the performance against savings rates
- The number of products available at present is limited