What is an offset mortgage?

While a low interest rate might be positive for mortgage borrowers, if The Bank of England’s base rate is low it may deprive those holding cash deposits of any meaningful returns over years of saving. But there is a potential solution available to mortgage borrowers who also hold cash savings - the offset mortgage.

An offset mortgage essentially involves linking the mortgage and savings accounts directly to each other. In simple terms, the cash balance in the savings account gets treated as a temporary overpayment towards the mortgage balance.

Offset mortgage example

For example, if a borrower has a mortgage loan of £200,000 but holds £40,000 in the linked offset account, interest would effectively only be charged against the £160,000. This is potentially more advantageous than holding the £40,000 in a separate savings account because the interest payable on the mortgage debt is likely to be higher than that which can be earned elsewhere on the savings.

There are two ways in which holding savings in an offset account can be of benefit – either as a reduction to the monthly payment, or as a reduction to the capital balance itself.

To illustrate how the 'reduce monthly payment' option works, let's continue the above example. Assuming the £200,000 mortgage bears interest at 2% then the monthly interest payment would be £333.33. Adding £40,000 to the offset account means only £160,000 will attract the 2% interest rate, and interest payments will therefore reduce by £66.66 per month.

The above interest saving equally applies under the 'reduce the capital balance' option, however rather than paying the lower monthly amount the borrower continues to pay the full £333.33 per month. In this instance the £66.66 becomes a capital repayment which begins the process of repaying the mortgage early - if repeated it can create a significant reduction to the overall mortgage term.

Who could benefit from an offset mortgage?

Anyone who has sufficient savings could potentially benefit from an offset mortgage, but they can be particularly beneficial for:

• Self-employed - if you're saving money to pay a tax bill you can do this in an offset savings account. Equally instead of keeping your cash reserves in a business account that you pay for, you could link this money to an offset mortgage.
• Higher rate tax payers - effectively the rate of mortgage interest can be grossed up at the higher rate of tax to give the gross return on the money.
• Those undertaking substantial home improvements - you might need to borrow a sizeable amount for home improvements and then pay the builders in tranches.
• People looking to buy additional property - you can borrow against your main residence and put the money in the offset account using it as a flexible facility.

It is worth noting that the mortgage interest rate payable on an offset mortgage is likely to be higher than an equivalent mortgage without an offset facility, so a minimum level of savings will need to be offset to cover the cost of the increased rate. Offset mortgages are not for everyone, but for those with sufficient cash based savings it could potentially be of benefit.