Offset Mortgage
What are they - How they work - Pros & Cons
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Last update : September 2010
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| Offset mortgages were introduced to the UK during the mid 1990s but have been slow to catch on.
People cite many reasons for this, including the fact that they're viewed as complex products, which they are not, and the fact that interest rates charged are not as competitive as other mortgage styles.
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| How an offset mortgage works |
| An offset mortgage combines your mortgage loan with your savings to reduce the overall size of the debt. As the size of the loan is reduced by the savings it also reduces the amount of interest paid. For example - |
- Your mortgage loan is £100,000
- Your current savings are £25,000
- Both are combined so the debt becomes £75,000
- Interest is therefore charged on £75,000 and not £100,000
- Of course because the savings are used to reduce the loan they won't receive any interest income
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| This contrasts with a traditional style of mortgage where the 2 sums would be kept totally separate meaning that interest would be paid on the £100,000 and also on the savings. |
| Tax savings is the main advantage of an offset deal |
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Saving tax is one of the main advantages of an offset mortgage and it works the best for higher rate taxpayers, ie those that pay 40%+.
Interest paid on savings is normally always taxed (unless held in a tax-free account such as an ISA or you don't earn enough income for it to be taxed). If you're a higher rate taxpayer the tax is a hefty 40%. But when you use your savings to reduce the mortgage loan the savings are theoretically receiving the same interest rate that the mortgage is charging. For example -
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- Your mortgage loan charges a 5% interest rate
- Your savings account pays 4% gross
- By combining the savings to reduce the loan your savings are theoretically earning 5% net
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But if your savings were in a separate account you wouldn't actually receive 4% because that's gross (before tax). So if tax is taken into consideration (at the higher rate of 40%) the net return would be a paltry 2.4%.
Or to put it another way - if you're using your savings to reduce your mortgage interest the 5% net you're earning is equivalent to 8.3% (5 x 1.6). And that rate would be unachievable for most, if not all savers.
For more information see - What's the difference between the Gross and Net interest rate
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| Offsets are very flexible |
| Another selling point with offset mortgages is that they're totally flexible and money can be paid in and then withdrawn at a later date. For example, the mortgage loan might be £100,000 and you have £25,000 in savings. |
- But assume a rich Aunt died and left you £30,000
- All of that could be immediately used to further offset the mortgage and reduce the monthly repayments
- But then, it's possible to withdraw all or part of the £30,000 in the future should you choose
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| Who are likely to benefit from offset mortgages |
| As a rule of thumb they're best suited to the following - |
- Higher rate taxpayers
- Those with large savings, in excess of 20% of the value of the loan
- Also, to a lesser extent, the self-employed
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| If you are all 3 of the above, then an offset mortgage should seriously be considered. Offsets are also suited for high paid contract workers with irregular salaries, perhaps working for 5 months then taking 3 months off before working for another 4 etc. |
| How interest is charged |
| Most of the time the rate will be variable, ie it will rise and fall in line with official base rates.
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| Positives |
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- Tax efficient - if savings are used to reduce the interest on a mortgage loan the savings earn the same rate as the interest rate charged on the loan which is also net of tax (see above for more details)
- Very flexible - easy to make overpayments, underpayments, payment holidays etc
- Can be cheaper than a traditional style mortgage - if you manage your financial affairs well then an offset mortgage can easily save you money as all available capital on a daily basis is used to reduce the size of the loan, hence reducing the interest payments
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| Negatives |
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- Forces you to use a certain bank - You might prefer to bank with the ABC bank but the XYZ one offers a good offset deal, if so you'll have to keep your main accounts there
- Maybe complex - The mortgages themselves are not that complex but they can become so when your financial situation is taken into account. For this reason it is important to research fully to see if this style of mortgage will suit you, not just for your present financial situation but also over the next several years
- Higher interest rates charged than more traditional mortgages - As a rule of thumb offset deals charge about 0.5% - 1% higher than more common mortgages but this has started to shrink over the last few years
- Need large savings - In the area of 20% (more is better) of the size of the loan, so £20k for every £100k worth of mortgagee
- Need to be organised - These mortgages work best for people who are good at organising their own financial affairs, ie paying money between accounts and good bill organisation (paying bills near the due by date but not later)
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| Buying tactics, tips and tricks |
| Use savings to make one large overpayment
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Want the right mortgage at the best price? Then start by downloading our free mortgage guide and follow the 4 easy steps.
If you currently earn a large income and have plenty of savings it might make more financial sense to use the savings to reduce the mortgage amount in a one-off payment.
Then use an aggressive remortgaging strategy to try to get the best deal every 2-5 years - More details on remortgaging. The interest rate via remortgaging should be cheaper than one charged on an offset deal. Plus, if you want to fix the rate it will be far easier than with an offset.
But do take all fees into account as well as realising that if interest rates rise there might not be a better deal at that time than the one you've already got.
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| Talk to a tax accountant |
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The more one earns the more complex the tax situation can become. This is why a tax accountant or adviser is often vital as they can help to streamline and make your financial affairs more tax-efficient.
As an offset mortgage is designed to bend and complement a person's financial situation it's worth talking through the pros and cons with a tax specialist.
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| Look for a deal that also offsets your current account |
| The best offset deals are the ones that combine both your savings and current account balance with your mortgage debt. This makes the overall debt even smaller, even if your current account averages just a few hundred pounds. |
| Direct Debit Trick |
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If you really want to get the maximum advantage out of an offset deal then try to pay all your direct debits and bills just before your salary is paid.
This means the money to pay the bills will sit in your account for an extra 2-4 weeks and hence reduces your overall debt. This trick might not seem that significant but it can probably save most people thousands over the years plus help to repay the loan slightly sooner.
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| LearnMoney.co.uk comment : |
Don't be off put by the generally higher interest rates on offset mortgages versus more traditional styles of home loans. This doesn't give an accurate picture because the potential tax advantages on your savings must also be taken into account.
Perhaps the simplest question to find out whether an Offset should be considered is -
Are you likely to always have large cash savings (in excess of 20% of your original mortgage loan)
If the answer is yes, then look closely at offset mortgages. If maybe or no, you should go with a more traditional deal.
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