The great offset mortgage trick: How to beat savings rates stuck in the doldrums and get debt-free quicker
Offset mortgages were a neat innovation a decade ago. Now with savers suffering, they are finally becoming a popular choice for many Britons looking to increase the interest they earn on savings.
An offset mortgage delivers a tax-efficient savings trick that can boost the return on your cash and get you debt-free quicker.
We crunched the numbers to explain exactly who can get the best most benefit.
The offset mortgage trick: Your homeloan can effectively deliver a better savings rate if you play your cards right.
Savers lose out to inflation and rates have fallen
The Bank of England has an inflation target of 2 per cent. Known as the Consumer Prices Index this is supposed to reflect the cost of living, for example how much food and energy costs.
Inflation reached a high of 5.2 per cent in September 2011 but in March 2014 it was down to 1.6 per cent.
To make any money on your savings, you need to to be earning an interest rate that beats the rate of inflation after tax, otherwise you are essentially losing rather than saving money. The tax you pay is 20 or 40 per cent depending on whether you are a basic or higher-rate taxpayer.
Banks and building societies have had little incentive in recent years to offer decent rates as they have had access to cheap funding on the wholesale markets as part of the Funding for Lending scheme.
The offset mortgage trick
One alternative for embattled savers is an offset mortgage. Offsets work by linking your savings to your mortgage.
Rather than earning interest – or paying tax – on your savings, your money is offset against your mortgage. As a result you pay less interest on that debt which, in turn means, you can clear your mortgage more quickly.
For example, if you had a £150,000 mortgage and £30,000 in savings, you would only be charged interest on £120,000. Your monthly repayments will probably be based on the full £150,000 meaning you effectively overpay each month and therefore pay your mortgage off more quickly.
Some lenders will allow you to reduce your mortgage payment to reflect the smaller debt, once your savings are taken into account but this wipes out much of the benefit as you won’t pay the debt off any quicker.
With an offset you retain access to your savings so it is a much more flexible option than using your savings to pay off a chunk of your mortgage as you can get at your money whenever you want, in the same way you’d be able to if it was in a standard easy access savings account.
With many offset providers, you can also link your current account to your mortgage and in some instances your cash Isa enabling you to really maximise the benefit.
How is an offset tax-efficient?
With an offset mortgage you give up the opportunity to earn savings interest on the cash you put in, but the equivalent return you get in terms of shaving interest off your mortgage is tax-free.
That is because while most people pay tax on savings, unless they are held within an Isa, there is no tax to be paid on the gain that you achieve by reducing your mortgage interest.
Tax on savings interest outside an Isa is paid at 20 per cent or 40 per cent, depending on whether you are a basic rate or higher rate taxpayer.
Who do offset mortgages suit?
Those who stand to make the greatest gains from offsetting are those with a large amount in cash savings and higher and top rate taxpayers.
This is because the more you have in savings the less interest you pay and the quicker you pay off your mortgage.
And the tax benefit from offsetting is greater for higher for higher and top rate taxpayers.
That said offsetting can still be worthwhile for those in the basic band too as they receive some tax relief, just not as much.
Ordinarily, income tax is payable on savings interest. However, with an offset mortgage you do not earn any interest on your savings so there is no tax to pay.
Just what sort of a saving can offsetting give?
We asked First Direct, which is one of the lenders to offer offset mortgages, to crunch some figures.
Assuming a three-year fixed rate of 2.74 per cent, a fee of £1,499 and deposit of at least 35 per cent, you could save more than £13,000.
We have assumed a £150,000 capital repayment mortgage borrowed over 25 years.
Someone with £15,000 in savings would save themselves £13,153 in interest and repay their mortgage 18 months early. In addition, a 40 per cent taxpayer would save £3,118 in income tax that they would have to pay if their money was in a standard savings account paying 2 per cent.
Up the savings amount to £50,000 and the interest saving would be a massive £40,695. What’s more you would be mortgage-free after 21 years six months, meaning you would be mortgage free three and a half years sooner than you were expecting.
The tax saving for a 40 per cent taxpayer would be £7,905, while a basic rate taxpayer could save themselves £3,953.
In reality, your savings are unlikely to remain flat but interest on offset mortgages is calculated daily so you will reap some benefit for each day you have savings, or money in your current account linked to your mortgage.
Offsetting can be a great option for the self-employed who put money aside each month for their tax bill as you can at least make it work hard for you until you have to part with it and give it to the taxman.
Where are the best offset mortgages and how do they compare?
While offsetting can be hugely beneficial, it is not a no-brainer and certainly if you only have modest savings you may decide to go for a standard mortgage and savings account.
Much will depend on the ‘premium’ you have to pay to offset. The rates on offset mortgages used to quite a lot higher than those available on the leading standard home loans. As a result, you tended to need about 25 per cent of the property’s value in savings for offsetting to be worthwhile.
However, the difference between the rates on some of the leading offset products and standard mortgages has narrowed meaning offsetting could be a suitable option for more people.
Alternative: Offsetting can be a great option for the self-employed
What savings rate do you need to beat an offset?
As well as looking at the rates available on non-offset mortgage products, you also need to consider what rate of interest you could earn on your savings if you don’t set them against your mortgage.
Based on a mortgage rate of 2.49 per cent, a basic rate taxpayer would need to earn 3.11 per cent or more on a standard savings account in order to generate an equivalent return to the benefit offsetting would have.
An offset is always worth investigating
It is estimated that offsets only account for about 6 per cent of the total mortgage market which is surprising.
Offsetting won’t be the best option for everyone but many people could benefit significantly from having an offset.
So, if you are looking for a new mortgage, it’s worth investigating whether an offset could be right for you rather than just sticking with standard mortgage and savings accounts.
As well as First Direct, other lenders offering offset mortgages include Woolwich (Barclays), Yorkshire, Chelsea and Leeds building societies.