How to save on interest with an Offset Mortgage?

Although their popularity declined significantly after the 2008 crisis, offset mortgages are still available on the market and are offered by many banks and building societies. There are reasons for this — although an offset mortgage is not an option for everyone, it can be very beneficial financially. In this article, you will learn how this type of mortgage product works and whether it is a good choice for you.

What is an Offset Mortgage?

An offset mortgage is a mortgage product linked to a special savings account, the balance of which reduces the amount on which interest is charged. It works in a very simple way:

• the borrower keeps their savings in a designated bank account;

• the interest rate on the mortgage is reduced by the amount accumulated;

• as a result, the owner pays less interest.

Remember that interest is calculated on the remaining mortgage balance.

To better understand this, let’s illustrate it with an example:

Let’s say you took out an Offset Mortgage for £300,000 and have already repaid £40,000. The outstanding capital is £260,000 — this is what the interest is calculated on. You have accumulated £20,000 in your offset savings account.

The amount on which interest is calculated is reduced by the amount of your savings: £260,000 - £20,000 = £240,000. Let’s assume that the interest rate on your mortgage is currently 5%. Next month, you will pay £240,000 * 5%/12 = approximately £1,000 in interest. If you did not have an offset account, the interest would be approximately £1,084.

Remember that with each instalment you pay off the capital, which means that the interest decreases by itself every month. A savings account supports this process and further reduces the amount you pay each month in interest. The more money you have in your offset savings account, the more you will save.

It is also worth mentioning that the money in such a savings account is readily available and you can withdraw it whenever you need it.

Why do banks agree to this?

At first glance, it seems that banks lose money because of offset accounts. This is partly true — by keeping your money in such an account, you reduce the amount of interest, which means that the lender earns less on the mortgage they have granted you. In practice, banks compensate for this loss by simply using the money from offset accounts for other operations. While your interest is lower, the bank uses your money to earn money in other ways — for example, to grant other mortgages or provide guarantees.

In addition, products with an offset account attract customers who need them – usually people with a higher level of wealth. This means that there are more customers, and thus the lender earns more on the interest charged and the savings held.

Offset Mortgage and overpaying your mortgage – comparing the benefits

An alternative to offset accounts is simply overpaying your mortgage. Overpaying involves transferring additional amounts to the lender, which directly reduce the balance of your mortgage. Both solutions mean you pay less interest — so which is more advantageous?

There is no clear answer to this question. Let’s say you want to use £5,000 to reduce your mortgage interest. Whether you pay it into an offset account or transfer it directly to the bank, the interest base will be reduced by the same amount – £5,000.

The actual difference lies in how these two mechanisms work, and the benefits that can be achieved depend on the borrower’s individual situation:

Flexibility of funds

By transferring £5,000 to an offset account, you reduce the interest rate base of your mortgage, but at the same time you keep this money for yourself and have the guarantee that if you need it, you can use it at any time. If you overpay your mortgage, this money is transferred directly to the bank, which means that you no longer own it and cannot get it back.

Impact on mortgage repayment period

Another difference lies in the impact of the selected mechanism on the mortgage repayment period. Overpaying a mortgage mortgage effectively reduces its balance, which shortens the expected mortgage period in two ways:

• the total capital is lower, so there are x fewer instalments;

• the reduction in capital also reduces the amount of interest, which in turn increases the capital portion of the instalment, thus accelerating the repayment of the mortgage.

In the case of an Offset Mortgage, the repayment period is not shortened – the funds in the offset account reduce the interest charged, but do not reduce the amount of capital borrowed. As a result, the savings resulting from the change in the mortgage schedule are smaller. As a side note, the best way to save on a remortgage mortgage is to shorten the repayment period.

Possibility of reducing mortgage instalments

An additional benefit of overpaying your mortgage is the possibility of reducing your instalments. If the lender agrees, after overpayment, you can reduce your monthly instalment in proportion to the overpaid amount. Offset Mortgages do not offer this option, although it must be said that most British lenders do not offer the option of reducing instalments through overpayment – in 99% of cases, paying additional funds will result in a shorter repayment period, so you will only feel the benefits after several or even several dozen years.

Early Repayment Charge

On the other hand, when overpaying your mortgage, you should be aware of the Early Repayment Charge (ERC). This is an additional fee imposed by the bank if you exceed the agreed overpayment limit. It applies during the fixed interest period and is usually a few per cent of the amount paid. Banks apply different values for the overpayment limit, but they usually range around 10% of the mortgage balance.

For example, if your mortgage balance is £200,000 and you overpay £30,000, you will have to pay a penalty of a certain amount, e.g. 4% of the surplus, i.e. £400 (£10,000 * 0.04 = £160.00 = 400).

An offset account has no restrictions or penalties, and the amounts you pay in are entirely up to you.

So who is an Offset Mortgage for?

There are several very specific cases in which an offset account with a mortgage works best. If they apply to your situation, it is definitely a good idea to consider such a product.

You have big savings

An offset mortgage works best when the funds accumulated in your savings account make a significant difference to the interest rate base. If you intend to keep £5,000 in your account for a £200,000 mortgage, your benefits will be minimal. The situation changes when you have £20,000-30,000 or more at your disposal – then an offset mortgage gives you a real advantage and enormous peace of mind.

You value financial liquidity

If your goal is to reduce your mortgage interest rate, but at the same time you do not want to ‘freeze’ your money for such a long time by overpaying your mortgage, an offset account is the ideal choice. The money held there reduces the interest on your mortgage and you can withdraw it at any time.

You are self-employed or have irregular income

If your income is irregular and there are periods of greater and lesser cash requirements, an offset account can act as a financial buffer. In better months, you deposit more into the account and save more on interest, and in worse months, you withdraw from the account and spend the money on other needs.

You are planning a large expenditure in the future.

If you are planning a major expense or investment, you probably do not want to spend a lot of money on overpaying your mortgage. With an Offset Mortgage, you can deposit all your accumulated savings into an offset account and reduce your mortgage interest.

Does an Offset Mortgage have any disadvantages?

Unfortunately, a mortgage with an offset account is not an ideal solution. First of all, this group of products is generally not cheap. Despite high LTV requirements, usually no higher than 85%, the interest rate on such a mortgage will almost certainly be relatively high. In practice, therefore, you are simply paying for convenience.

Statistics show that the average mortgage interest rate in the UK is currently around 4.3% per annum, and is likely to fall over the next few months. In practice, therefore, mortgage interest rates are only slightly above inflation and are often significantly lower than the rates of return you can achieve by investing in a variety of assets, such as short-term rental properties through a holiday let mortgage. Of course, every investment involves risk and instead of a profit, you may incur a loss, but if you are thinking about a 20-30 year horizon, investing your surplus cash in stocks or pension funds may be an alternative worth considering.

It is also worth being aware that offset mortgages are relatively rare products and their availability is limited. As a whole-of-market credit broker in the UK, we work with literally a handful of lenders offering this type of mortgage. By comparison, the total number of banks and credit companies we work with is almost 350!

Family Offset Mortgage

A Family Offset Mortgage is a type of offset mortgage that is definitely worth knowing about. In this case, the offset account works exactly the same, but it does not belong to you, but to a selected member of your family. This solution can be a really great choice if someone in your family has large savings – then, for example, you can use your financial surplus to overpay your mortgage, benefiting in two ways.

Summary

An offset mortgage is a mortgage linked to a special savings account, the balance of which reduces the amount on which interest is calculated. This allows you to reduce the cost of the mortgage without having to overpay it and freeze your funds for many years. However, this solution is not always ideal, so be sure to compare its benefits with those of actually overpaying your mortgage. If you don’t have your own savings but could use funds from a family member, there are Family Offset Mortgages available on the market that work in exactly the same way, except that the money in the offset account belongs to your relative.

Do you have to pay tax on savings in an offset account?

No, although an offset account offers real financial benefits, you do not have to pay any tax on them.

Do offset mortgages have higher interest rates?

It is often the case that products with an offset account have slightly higher interest rates than standard offers. However, if the borrower has sufficient savings, the higher interest rate is compensated for.

Can funds in an offset account generate profit?

No, it is not possible for funds in an offset account to earn additional interest or be invested in financial instruments.