Published: 25 October 2012 Topic: News,Money,Mortgages
With savings rates falling left right and centre, many savers are looking for alternative ways to make their money work harder for them.
One possible option is an offset mortgage. Offsetting can be a great way of getting more from your savings and paying less tax. However, it won't be the right thing for everyone.
What is an offset mortgage and how does it work?
With an offset, your savings are linked to your mortgage. Instead of earning interest on your savings, the money is set against your mortgage. As a result you pay less interest on that debt.
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.
As well as being mortgage-free sooner, offsetting can also save you tax - usually, you pay income tax on interest you earn on your savings. However, because you don't earn any interest if the money is offset against your mortgage, there is no tax to pay, making this a particularly attractive option for higher and top rate taxpayers.
Of course, you could have a standard mortgage and use your savings to pay a chunk of it off, but if you do this it is difficult to get at that money again if you ever need it. With an offset, you can access your savings at any time.
Also, most mortgage products restrict the amount you can pay off each year - it is usually capped at 10% of the outstanding balance. Offsets have no such restrictions.
So just how much could you save by offsetting?
We asked First Direct, which is one of the lenders to offer offset mortgages, to crunch some figures. They are all based on First Direct's two-year fixed rate offset which has a rate of 2.89%, a fee of £999 and is available to those with equity or a deposit of at least 35%. We have assumed a £150,000 capital repayment mortgage borrowed over 25 years.
Someone with £15,000 in savings would save themselves £13,339 in interest and repay their mortgage 21 months early. In addition, a 40% taxpayer would save £3,308 in income tax that they would have to pay if their money was in a standard savings account paying 2%.
Up the savings amount to £50,000 and the interest saving would be a massive £41,366. What's more, you would be mortgage free after 20 years and six months, meaning you would be mortgage free four and a half years sooner than you were expecting. The tax saving for a 40% taxpayer would be £7,831 while a basic rate taxpayer could save themselves £3,916.
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.
Is an offset right for everyone?
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 and the amount of interest you can earn on your savings.
The rates on offset mortgages used to be quite a lot higher than those available on the leading standard home loans. As a result, you tended to need about 25% 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.
You also need to factor in savings rates. Obviously you want the interest you save on your mortgage, coupled with the tax you'll save, to be greater than the amount of interest you would earn if you kept your money in a savings account. And this is why offsetting is looking particularly attractive at the moment.
Based on First Direct's two-year offset rate of 2.89%, a basic rate taxpayer would need to earn 3.67% or more on a standard savings account in order to generate an equivalent return to the benefit offsetting would have. A 40% taxpayer would need a savings account paying 4.92% or more, while someone in the 50% band would need to be earning at least 5.94%. The problem at the moment is this is easier said than done.
The leading easy access account is Principality Building Society's eSaver Issue 7 at 2.65%. If you can afford to lock your money away you can earn more, but even then rates aren't that great at the moment. The highest rate is on State Bank of India's five-year Hi-Return Fixed Deposit at 4.20% - bear in mind that you won't be able to access your money during the fixed term.
You could go for a cash ISA if you've not yet used this year's ISA allowance as interest is tax free. Coventry Building Society's 60-day Notice ISA is paying 3.25% and is available online or via a branch or post.
An offset is always worth investigating
It is estimated that offsets only account for about 6% 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, particularly at the moment with savings rates so low.
As well as First Direct, other lenders offering offset mortgages include Woolwich (Barclays) and Scottish Widows, and Yorkshire, Chelsea and Leeds building societies.