What is an offset mortgage and should you get one?
You may have heard of offset mortgages and you may even know someone who has one. If you’re not really sure what they are and how they work, don’t worry, you’re not alone. Only around 4% of borrowers have an offset mortgage, but if you speak to someone who’s got one, they will probably tell you how great they are.
In this post, we’ll teach you how an offset mortgage works in simple terms and the pros and cons of them. We’ll also explore whether your circumstances make an offset mortgage an option worth considering.
How do mortgage offset accounts work?
An offset mortgage links your mortgage to a savings account. You can think of it as a mortgage and savings account combined into one account. Both your mortgage and your savings account usually has to be with the same bank or building society. Essentially, the value of your total savings is deducted from your lump-sum mortgage value, therefore, you only pay interest on the remaining mortgage value. In other words, the savings “offset” your mortgage, thereby reducing your interest payments. You won’t earn interest on your savings but you will save on mortgage interest payments.
You may be asking yourself, isn’t this the same thing as mortgage overpayment? The simple answer is no. You can think of the savings deposit in an offset mortgage as a “temporary overpayment”. The savings reduce your mortgage interest while they are held in the account. However, you have the flexibility to take your money out if you need, and once you do, you’ll be paying more interest on the mortgage. In comparison, an overpayment on your mortgage is not flexible. An overpayment permanently reduces your lump-sum mortgage and is no longer available for you to spend elsewhere.
Let’s take a simple example. Jackie has a mortgage of £100,000, on which she pays 4% interest. Jackie offsets her mortgage with £10,000 in savings. This means she is only paying 4% on £90,000, rather than £100,000, which could save her up to £400 per year.
So what’s the catch? While Jackie saves mortgage interest, she is missing out on interest she could be earning on £10,000 of savings. Suppose a savings account offers 2%, Jackie is missing out on £200 interest, although this may be even less if she has to pay tax on it. In comparison, she is saving £400 on her mortgage interest savings. Therefore, overall, the offset mortgage saves Jackie money since her £400 of mortgage interest savings are more than the £200 she misses out on.
Whilst all offset mortgages work on these principles, there are different options. You can use the “offset” to either lower monthly payments or shorten the length of your mortgage term.
What are the benefits and drawbacks of an offset mortgage?
As interest rates on savings are generally low, the savings you make on mortgage interest payments will, in general, be greater than the interest you could earn on your savings. Don’t forget, you’ll also avoid paying the 20-25% tax on interest earned on savings since you’re paying no tax on the interest you save.
Offset mortgages offer flexibility to how you use your savings. Unlike a mortgage overpayment, you’ll still have access to your savings. This can be particularly useful if you need spare cash available to pay for unexpected bills such as house repairs.
On the flip side, you’ll also have the freedom to add more deposits to the savings account to reduce your mortgage interest even more. If you can get into the regular habit of making regular deposits into the savings account, you could save thousands of pounds on interest payments through the course of your mortgage.
Some offset mortgages allow you to link savings account for more than one person. This can be handy for parents looking to help their children on to the property ladder. These are known as “Family Offset Mortgages”. By committing some savings to your child’s offset mortgage, you’ll help reduce their monthly payments while still retaining control of your savings. However, there are restrictions. The parents cannot get their money back until the mortgage has been paid to within 75-80% of the property value.
Offset mortgages have their drawbacks and limitations, so it’s worth weighing up your options. The main drawback to an offset mortgage is the interest you’ll lose on your savings. If you’re somewhat dependent on savings interest to cover your bills, then you may want to think carefully about how your lifestyle may be affected by choosing an offset mortgage.
Don’t forget, your savings will also lose their spending power as they will not grow over time. For example, £10,000 used to offset your mortgage today will not have the same value ten years from now due to inflation.
Offset mortgages can have slightly higher rates than normal mortgages, on average 0.2%-0.5% more, which might undo some of the benefits of offsetting. For this reason it's worth checking that an offset mortgage will still save you money compared to a standard mortgage and savings account. Also be sure to check the terms of the offset mortgage as some lenders charge fees for overpayments on offset mortgages.
Offset mortgages often offer a lower loan-to-value (LTV) ratio than conventional mortgages. In some cases the mortgage lender can require as much as a 25% deposit.
Lastly, your choice of offset mortgage may be limited. The offset mortgage market is tiny compared to the standard mortgage market and the criteria for approval can make it tricky to qualify for one.
Is an offset mortgage worth it?
While there are clear benefits to an offset mortgage, this option may not be suitable or even possible for everyone.
For starters, you’ll need a good chunk of savings to qualify and offset the mortgage. As a general rule of thumb, you should have savings that are 20-25% of your lump-sum mortgage.
Offset mortgages are particularly attractive to higher rate taxpayers. An offset mortgage allows you to avoid the 40-45% tax you would otherwise be paying on the interest earned on savings.
There are other circumstances where an offset mortgage could make a lot of sense. If you’re self-employed, for example, an offset mortgage is well worth considering. Self-employed individuals need to set money aside to cover their tax bills. This money could be used in the interim to reduce mortgage payments.
Another case is if your parents wish to offer support to reduce mortgage payments without losing control of their savings. Here, you may want to consider a “Family Offset Mortgage” as discussed earlier.
To get started, why not try an offset mortgage calculator, to work out how much you’d save. Once you’ve done your research, it may be worthwhile to seek specialist advice on your mortgage decision to decide whether or not it’s the right move for you.