A couple of weeks ago in a post on whether you should overpay your mortgage or invest the money, one of the experts I spoke to mentioned offset mortgages as an option.
It’s such an interesting idea and, I feel, so little known that I wanted to do a deep dive into what it’s all about.
What is an offset mortgage?
An offset mortgage is basically a type of specialist loan product.
It lets you combine your mortgage balance and any liquid assets, such as money in your current and savings accounts, into a sort of super account that’s held with the same financial institution, whether that’s a bank or building society.
The idea is that you have your traditional mortgage, which you continue to pay off every month just like any other mortgage; and then any additional monies in your other accounts are used to “offset” your mortgage and lower the amount of interest you pay (rather than the interest rate itself).
For example, if your mortgage is £150,000, and you have a current account/savings balance of £10,000, having an offset mortgage means you’ll only pay interest rate on a balance of £140,000 – but you won’t receive any savings interest on that £10,000.
If your current account/savings balance goes up to £20,000, then you’d only have to pay interest on £130,000; but if you withdrew some money and your current account/savings balance drops to £5,000, you’d have to pay interest on £145,000.
Depending on the lender, you can choose to shorten your mortgage term or reduce your monthly repayments, so in that sense it works like overpaying your mortgage except you still have access to your money whenever you need it.
What are the advantages of an offset mortgage?
“Offset mortgages are often popular with buyers who have a substantial savings pot during times of low interest rates,” says Pete Mugleston, managing director and mortgage expert for Online Mortgage Advisor.
“Offsetting your savings against your mortgage might be a better use of your money, since it’s unlikely to grow when rates are low, like they are now.”
This benefit is especially useful for contractors and freelancers who might need to put aside large chunks of money for the tax bill, or anyone with a sizeable emergency fund that needs to be easily accessible.
“Another benefit of an offset mortgage is that it can be used to help a family member onto the property ladder,” according to Pete.
“For example, a parent could offset their savings against a mortgage for one of their children to lower the overall risk and help improve their eligibility.”
And of course, it makes more financial sense if you’re in the higher rate or additional rate tax brackets as you may have to pay income tax on any income from savings but there is no tax to pay on the money you save through lowering interest repayment.
That’s because everyone has a Personal Savings Allowance that’s determined by their tax band and anything over this allowance is taxable at the same level as their income tax.
For higher rate taxpayers this allowance is £500 a year, while additional rate taxpayers have zero.
If you have a large lump sum, additional rate taxpayers should always opt for an offset mortgage but for higher rate taxpayers it would depend on how much that lump sum is and the interest income from it.
Why an offset mortgage isn’t for everyone
Offset mortgages are not the right solution for everyone though, especially if you don’t or can’t normally put a lot of money towards savings.
Pete explained: “Offset mortgages are definitely not the most cost-effective mortgage solution for all.
“Not only are the interest rates higher in most cases, but a lot of providers will request a loan to value ratio of at least 75% before considering you for this type of mortgage, meaning you could be required to pay a deposit of 25% or more.”
Another problem is that not all providers offer an offset mortgage, which means your options are more limited. Plus, you have to have all your savings with the same bank or building society as your mortgage, which could mean having to switch.
Should you overpay your offset mortgage or leave the money in your account?
You could save a lot of money by overpaying your mortgage so you may well be wondering why you wouldn’t just pay your mortgage off earlier instead of putting it into an account to offset your mortgage.
The answer is ease of access.
Pete said: “Most people want at least a buffer, and others who have various portfolios and other things they want to invest in don’t want all their money tied up in property.”
Essentially, once you overpay your mortgage, you don’t have access to that money again until you resell or remortgage. But if your money is in an offset mortgage, you can still use it anytime you need.
If you are considering an offset mortgage, it’s easiest to find one through a whole-of-market mortgage adviser, who will be able to tailor their suggestions according to your circumstances.