How Does an Offset Mortgage Work?
Example: you have a £150,000 mortgage and £15,000 in a linked savings account. The value of the savings reduces the portion of the loan on which interest is paid down to £135,000, rather than the full amount.
This means that more of your monthly repayments go towards paying off the loan rather than the interest charges. Consequently, with an offset mortgage you could save thousands of pounds over the course of the loan and repay it in full much earlier than a standard mortgage.
Similar Mortgage Types
Some offset mortgages allow you to link both a current account and a savings account. Therefore, offset mortgages can often be compared to current account mortgages, where the mortgage loan becomes akin to a giant overdraft. The key difference with offset mortgages is that they keep all accounts separate, allowing you to reap the full benefits of linked accounts.
There are also similar kinds of mortgages available for first-time buyers, where savings (often belonging to family) can be used as a form of bond to reduce the loan-to-value requirement.
Advantages of an Offset Mortgage
- Making Savings Work Harder
In taking out an offset mortgage, you sacrifice the interest that you would have gained from your savings to pay off your loan faster. But, because the interest charged on your mortgage loan will almost invariably be higher than the interest you would have gained from those savings, you’re making them work harder.
The detrimental effect that the Funding for Lending Scheme has had on savings accounts shows no signs of abating. By using savings to overpay on your mortgage, you could save far more in repayments than you would have gained in interest through standard savings accounts. And if you are keen to retain full access to your savings, an offset mortgage might prove the ideal solution.
- Tax Efficient
Offset mortgages can be a tax-efficient option. Since your savings are working to reduce the cost of your mortgage rather than earning interest in their own right, you will not have to hand anything over to the taxman.
Offset mortgages are designed to be flexible to your needs. So, if you increase the value of your savings, the amount of the loan on which you pay interest will fall. But if you need access to your savings – in an emergency, for example – all that will happen is that the loan amount on which interest is paid will increase to reflect what is left in your account.
Your monthly payments themselves should not fluctuate; it is likely that they will be reviewed every year to reflect the higher equity stake you hold in your property and any major changes in the average value of your linked savings.
- Repayment Options
Offset mortgages tend to allow you to repay a lump sum off your balance without incurring a penalty charge (a standard mortgage might allow overpayment by 10% before charges apply). You might also get the option of a payment holiday if you are deemed to have overpaid over a set period.
Disadvantages of an Offset Mortgage
- More Costly
On account of the flexibility on offer – notably, your ability to shrink the interest component of your loan and repay it years earlier with few restrictions – offset mortgages tend to be more expensive.
Nevertheless, if you're able to maintain a healthy volume of savings, you’ll need a very competitive standard mortgage rate to match the effective rate you could achieve through the right offset mortgage.
- Minimum Balance
Some lenders set a recommended minimum average savings balance because of the higher average cost of an offset mortgage over standard mortgages. It's not such a bad target, however, as it improves the loan conditions for the borrower as well as reducing the risk for the lender.
Great for Savers:
For diligent savers and those with healthy current account balances, an offset mortgage could prove to be a very cost-effective option.
Efficient Use of Savings:
Offset mortgages are an efficient use of savings in the current climate. If homeowners are willing to sacrifice the poor returns available through savings accounts, in return, they will bypass the taxman, derive a higher effective rate by using their savings to reduce their mortgage costs and retain full access to their cash.
Expensive in the Short-Term. Worthwhile in the Long-Term?
Because of the flexibilities these mortgages offer, they tend to be more expensive. Homeowners must investigate whether their current balance and anticipated level of saving in the future will make this a viable option in the long term.