How to save on interest with an Offset Mortgage?

Offset mortgages are less common than standard mortgages, and only a limited number of banks and building societies offer them. Although an offset mortgage is not an option for everyone, it can be financially beneficial. 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 balance on which interest is charged is reduced by the amount held in your savings;

• 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 £1,083.

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 may seem that lenders lose money on offset mortgages, because your savings reduce the interest they earn. In practice, lenders price the offset feature into the rate, which can be higher than on comparable standard mortgages. Offset products also tend to suit borrowers with substantial savings.

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 lender, the balance you pay interest on 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 balance you pay interest on, but at the same time you keep this money and you can normally withdraw it if you need it. If you overpay your mortgage, the money goes to the lender to reduce your balance, and you usually cannot take it back unless your mortgage has a borrow-back (flexible) feature.

Impact on mortgage repayment period

Another difference lies in how each option affects the mortgage term. Overpaying a mortgage reduces its balance, which shortens the expected term in two ways:

• the outstanding capital is lower, so there are fewer monthly payments;

• the lower capital also reduces the interest, so a larger share of each payment goes towards the capital, which speeds up repayment.

With an offset mortgage, your savings reduce the interest charged but not the capital borrowed. If you keep your monthly payments the same, the interest you save usually means the mortgage is repaid sooner. Some lenders instead let you use the offset benefit to lower your monthly payment. As a side note, a shorter term usually reduces the total interest you pay, although monthly payments are higher.

Possibility of reducing mortgage instalments

With overpayments, lenders differ on whether they reduce your monthly payment or shorten the term, so check your lender’s terms. The same applies to an offset mortgage: depending on the lender, the benefit can shorten the term or lower your monthly payment.

Early Repayment Charge

On the other hand, when overpaying your mortgage, you should be aware of the Early Repayment Charge (ERC). This is a fee charged by the lender if you exceed your overpayment allowance. It usually applies during an initial deal period, such as a fixed rate, and is typically a percentage of the amount repaid above your allowance (for example, up to 5% at some lenders). Overpayment allowances vary by lender and product (10% of the outstanding balance a year, for example), so check your mortgage offer.

For example, assume your mortgage balance is £200,000, your annual overpayment allowance is 10% (£20,000) and the ERC is 4%. If you overpay £30,000, you go £10,000 above the allowance, so the charge is 4% of £10,000 = £400.

Paying money into or out of the linked offset savings account does not normally trigger an ERC, although the offset mortgage itself can still carry ERCs for overpayments or early repayment.

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 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 balance you pay interest on. 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 the interest you save can be much more significant, although whether it outweighs a possibly higher rate depends on your deal.

You value financial liquidity

If your goal is to reduce the interest you pay, 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 may suit you. 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. Offset deals often need a bigger deposit (a maximum LTV of around 85%), and the interest rate on such a mortgage can be higher than on comparable standard mortgages. In practice, therefore, you are simply paying for convenience.

Whether an offset makes sense depends on how your mortgage rate compares with what your savings could otherwise earn after tax.

It is also worth being aware that offset mortgages are relatively rare products and their availability is limited. Extend Finance is a whole-of-market mortgage broker with access to products from more than 100 lenders. Only a limited number of the lenders available to us offer offset mortgages; availability depends on their products and criteria.

Family Offset Mortgage

A family offset mortgage is a type of offset mortgage that is worth knowing about. The offset account works in the same way, but it belongs to a selected member of your family rather than to you. This can help if a relative has large savings: their savings reduce the interest you pay, while the relative keeps their savings, which normally earn no interest while linked.

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 keeps enough savings in the offset account, the interest saved can outweigh the higher rate.

Can funds in an offset account generate profit?

No. Money held in an offset savings account normally does not earn interest; its benefit is the mortgage interest you save.