How does an offset mortgage work? | Complete Guide

Over the decade, we have received many enquiries from British residents asking how an offset mortgageA mortgage where the borrower's savings are offset against t... works.

Like many people, you might be borrowing money and paying interest on your mortgage, but at the same time, saving money and earning interest on your savings.

It might seem entirely logical and practical, therefore, to combine the interest paid with interest earned into a single account – not only as a matter of convenience but also to ensure that your money is working its hardest for you. In this article, we discuss the workings of an offset mortgage. We will also answer frequently asked questions such as “offset mortgage, how does it work?” or “How does an offset mortgage work in the UK”?

How does an offset mortgage work?

An offset mortgage may be set up if you are borrowing and saving with the same mortgage provider.

In place of a standard savings account, your lender sets up a special account linked to your mortgage, into which you also deposit your savings. In that offset account, the amount of your savings is offset against your outstanding mortgage balance. That means that you are only paying mortgage interest on the balance remaining once the value of your savings has been deducted from your outstanding mortgage – potentially creating a significant impact on the outstanding mortgage balance.

Your savings are not used to actually pay off any of the mortgage balance, but the two balances simply sit side by side, with your savings helping to reduce the mortgage interest you pay.

An offset mortgage may prove an ideal way to save money. The economic case is made by comparing what a standard mortgage might be costing you, how much you are currently earning on your savings and what the comparable figures might be if you set up an offset mortgage account with your lender. To help you make that comparison and calculation, the Money Saving Expert has published a ready-reckoner to give you a broad indication of the likely effects of setting up an offset mortgage.

An example

An example might help to illustrate just how this might work.

Say you have an outstanding mortgage balance of £100,000 and savings of £10,000, which you combine into a single offset mortgage account. Because the £10,000 in savings is used to offset the mortgage balance, you only pay interest on the net balance – £90,000. In a year, therefore, with interest at, say 3%, you stand to make a saving of some £300.

A regular savings account is likely to pay somewhat less in interest (if it were 2%, say, you would earn £200 in interest on your £10,000 savings). Importantly, though, and unlike an offset mortgage, you may also have to pay income tax on income earned by way of interest on your savings.

Cheaper monthly instalments or a shorter mortgage

An offset mortgage is typically used to reduce the cost of the monthly mortgage repayments you pay – thanks to the savings on interest charged on the reduced balance of your outstanding mortgage.

Alternatively, however, those savings might be used to shorten the term of your mortgage. You continue to pay the full amount of interest on your mortgage balance. Still, the offsetting element of your savings reduces the effective term of your mortgage – and you become mortgage-free at an earlier stage in your life, explains Money Facts.

The pros and cons

Pros and Cons of Offset Mortgages in the UK

Pros:

• Potentially save more on interest: Compared to a regular savings account, offset mortgages can significantly reduce your mortgage interest payments. Your savings directly offset the loan balance, meaning less interest accrues over time.
• Faster repayment: You can choose to keep your monthly payments the same and use your savings to shorten your mortgage term. This saves you money on overall interest and frees you from the debt quicker.
• Flexibility and access: You can easily withdraw funds from your offset account whenever needed, without penalty. However, remember that this will increase your monthly mortgage payments.
• Tax-free savings: Unlike regular savings accounts, where interest is taxable, offset mortgages offer tax-free savings on the interest you “earn” by reducing your mortgage balance.
• Choice of repayment: You decide how your savings are used – either to reduce monthly payments or shorten the term. This allows you to tailor the mortgage to your financial goals.

Cons:

• No interest earned on savings: Your savings in an offset account won’t earn any additional interest, potentially causing them to lose buying power over time due to inflation.
• Higher fees: Offset mortgages can have higher fees compared to standard mortgages, so it’s important to compare costs before making a decision.
• Requires discipline: Maintaining a healthy savings balance is crucial for an offset mortgage to be effective. Withdrawing funds frequently can negate the benefits of the offset.
• May not be for everyone: Offset mortgages are best suited for borrowers with consistent savings and a long-term mortgage commitment.

Overall, offset mortgages offer a unique way to save on mortgage interest and potentially reach mortgage freedom faster. However, it’s important to weigh the pros and cons carefully and consider your individual financial situation before deciding if it’s the right choice for you.

Remember to consult a financial adviser or mortgage broker for personalised advice and guidance on whether an offset mortgage is right for you.

How does an offset mortgage work in the United Kingdom?

An offset mortgage in the UK is a clever blend of a traditional mortgage and a savings account designed to save you money on interest and potentially shorten your mortgage term. Here’s how it works:

1. Linking your accounts: You link your current account, savings account, or a dedicated offset account directly to your mortgage.
2. Offsetting the balance: Every day, your mortgage lender calculates the combined balance of your linked accounts and subtracts it from your outstanding mortgage balance. So, if you have £20,000 in savings and a £100,000 mortgage, you’ll only pay interest on the remaining £80,000.
3. Reduced interest: Since you’re paying interest on a smaller balance, your monthly repayments decrease. That means you’re effectively chipping away at your mortgage faster, even though your actual payments may be lower.
4. Flexible options: You can choose how to use your offset savings:

• • Reduce monthly payments: Keep your repayments the same and let your savings work behind the scenes, shortening the overall term of your mortgage.
  • Maintain term & save money: Increase your payments with the help of your offset savings, paying off your mortgage in the same timeframe but saving money on total interest.

5. Access to funds: Your offset savings remain readily accessible. You can withdraw money at any time, although doing so will increase your outstanding mortgage balance and potentially your monthly repayments.

Benefits of offset mortgages in the UK:

• Potentially save thousands on interest: Over the long term, the reduced interest can bring significant savings.
• Faster mortgage repayment: You can choose to repay your mortgage quicker, achieving mortgage freedom sooner.
• Tax-free savings: Unlike regular savings accounts, you don’t pay income tax on the “interest” you “earn” by reducing your mortgage balance through offsetting.
• Flexibility and control: You decide how your savings are used, tailoring the mortgage to your financial goals.

Things to consider:

• Higher fees: Offset mortgages often have higher fees than standard mortgages.
• No interest earned on savings: Your savings won’t grow in value while in the offset account, potentially losing buying power over time due to inflation.
• Requires discipline: Maintaining a healthy savings balance is crucial for the mortgage to be effective.

Is an offset mortgage right for you?

Offset mortgages are ideal for borrowers with a long-term mortgage commitment and consistent savings. If you’re disciplined with your finances and want to save money on your mortgage while enjoying the flexibility, it could be a great option. However, it’s important to compare different mortgage deals, consider the fees, and consult a financial adviser to determine if it’s the right fit for your individual circumstances.

Next Steps

Getting an offset mortgage can be a great way to save money on your mortgage while taking advantage of the flexibility. If you’re considering one, take the time to compare different deals and discuss your options with a financial adviser. With the right guidance, an offset mortgage could be a smart choice for you. If you are the one who wants to know more about how an offset mortgage works, we suggest you contact our team of experts, who can help you with your mortgage application process.

FAQs

How Does an Offset Mortgage Work in the UK?

Offset mortgages allow you to link your savings account to your mortgage loan. This means the money in your offset savings account is counted against your outstanding mortgage balance. For example, if you have a mortgage of £200,000 and savings of £20,000 in an offset account, you only pay interest on £180,000 of your mortgage. This can lead to substantial savings on mortgage interest payments. To understand this better, use any offset mortgage calculator.

What are the Advantages and Disadvantages of Offset Mortgages? The main advantage of an offset mortgage is the potential savings on interest payments, leading to lower monthly mortgage payments or a shorter mortgage term. It’s a flexible mortgageA type of mortgage that allows the borrower to overpay, unde... option, suitable for those with regular savings. However, offset mortgage rates may be higher than standard mortgage rates, and if you don’t have much saved, the benefits might be limited. For detailed financial advice, consider speaking with an experienced mortgage adviser.

Are Offset Mortgages a Good Idea? What Should You Consider?

Whether an offset mortgage is a good idea depends on your circumstances. If you’re a higher or additional rate taxpayer, offsetting can be particularly beneficial as you won’t pay tax on savings interest. They are also great for first-time buyers stepping onto the property ladder or anyone with lots of money saved. You should weigh the potential cost savings against the rates on the mortgage. Discuss your situation with an independent mortgage broker.

How Do 100% Offset Mortgages Work and What Happens When the Offset Account Exceeds the Mortgage?

In a 100% offset mortgage, every penny in your savings account is offset against your mortgage. If your offset account exceeds your outstanding mortgage balance, you won’t pay interest as your mortgage is essentially paid off. However, it’s a rare scenario and needs careful financial planning.

Is it Better to Pay Down the Mortgage or Utilise an Offset Account?

This depends on your financial goals. Paying down the mortgage reduces the outstanding balance while using an offset account and offers flexibility and potential savings.

Does an Offset Mortgage Reduce Monthly Repayments?

Yes, an offset mortgage can make your monthly mortgage repayments cheaper by reducing the interest charged on the outstanding balance. This could either lower your monthly payment or shorten the mortgage term.

What Are the Limits and Rules Around Offsetting a Mortgage?

The limits depend on your mortgage lender and the specific offset mortgage product. Some may allow you to offset 100% of your savings, while others may have a cap. It’s crucial to read the mortgage offer letter and discuss this with your mortgage advisor.

How Can You Optimize the Use of an Offset Account for Maximum Benefit?

The best way to use an offset account is to maintain a healthy balance of savings. Regular savings in this account can lead to greater interest savings over time. Consider your monthly saving ability and your overall financial plan.

Can I Get an Offset Mortgage if I’m Self-Employed or Seeking a Large Loan?

Yes, self-employed individuals and those seeking large loans can apply for an offset mortgage. The application process might be more detailed, so prepare your financial documents thoroughly. For guidance, schedule a mortgage appointment with a specialist mortgage broker.

What Are Some Examples of Offset Mortgage Scenarios?

For instance, if you have a mortgage loan of £250,000 and savings of £50,000 in an offset account, you only pay interest on £200,000. This could lead to significant interest savings or allow you to pay off your mortgage earlier.

For more information and personalised advice, don’t hesitate to reach out to our team of specialist mortgage advisers. We’re here to help you navigate the mortgage market and find the best mortgage deal for your needs.