With interest rates at rock bottom, some borrowers may be tempted to use savings to overpay their mortgage.
As a general rule, if you have a substantial amount of cash earning next to nothing in the way of interest, it can make sense to overpay on your mortgage once you’ve cleared more expensive debts, such as credit cards or personal loans.
Adrian Anderson, director at broker Anderson Harris, says: “This is particularly true if the rate of interest you are paying on your mortgage is higher than the rate of interest you earn on your savings after tax.” But before rushing in to this decision, it is worth exploring whether you might be better applying for an offset mortgage. These products allow you to use your savings to reduce your mortgage term or monthly payments.
Mr Anderson adds: “This still reduces the interest you pay, but you still have access to savings in case of emergency.”
How does an offset mortgage work?
This type of loan links a mortgage and a savings account to help you save money on mortgage interest; you do this by forgoing interest on your savings. Brian Murphy, head of lending at the Mortgage Advice Bureau, says: “This arrangement allows you to ‘offset’ the amount that you’ve got in your savings against the interest you pay on your mortgage. For example, if the balance outstanding on your mortgage is £200,000 and you have £50,000 in your savings account, with an offset you would pay interest on the £150,000 difference.”
As you pay interest only on the amount left after you subtract your savings from your mortgage, the more cash you have to offset, the more interest you save. As well as reducing the interest you pay, you can also cut your mortgage term by maintaining the original mortgage payment and overpaying slightly.
“Some lenders will give borrowers the choice of reducing payments or paying off their mortgage more quickly,” says Mr Hollingworth. “For example, a £150,000 repayment mortgage over 25 years at a rate of 3% would cost £711 a month. However, by offsetting £20,000 in savings, this would mean you would repay the mortgage two years and two months early – and save almost £19,500 in interest.”
While you can pay in and withdraw cash from the separate savings account, you need to be aware that an early repayment charge (ERC) could apply to the mortgage itself.
Hang on to your savings
“With mortgage rates at record lows, this actually lessens the case for paying off your mortgage,” says Mark Harris, chief executive at broker SPF Private Clients. “As your home loan is not costing you much in the way of interest, it may make sense to hang on to your savings in case you need them. The beauty of an offset is that you can retain access to your cash as a safety net while at the same time reducing the interest you pay on your mortgage. It’s a win-win.”
If you’re struggling to find a decent return, an offset mortgage deal could also help you make the most of your money. “Those hoping to pay off their mortgage early while interest rates are at record lows should be wary,” says David Copland, director of
TMA Mortgage Club.
“Disciplined borrowers looking to keep a rainy-day fund would be wise to explore offset deals as an alternative.”
“The average easy-access rate now stands at a disappointing 0.39%, while the average offset fixed-rate mortgage comes in at 2.28%,” says Rachel Springall, a finance expert at analyst Moneyfacts. “It’s clear to see how a borrower who opts for an offset could use their savings to reduce the interest paid on their mortgage while simultaneously having instant access to their savings pot.”
Mr Copeland adds: “While today’s dire savings rates may tempt customers to bite the bullet, most mortgages only allow a certain amount of capital to be paid off each year.” In most cases, lenders will let you overpay by up to 10% a year without penalty.
However, the degree of overpayment permitted can vary by lender – and also by the specific deal. At the same time, ERCs can typically be in the region of 3% to 5% of the amount repaid. These penalties are levied against borrowers if more than the capital allowance is repaid, and can make it expensive to pay off your mortgage early.
Plus you need to bear in mind that once you’ve overpaid your mortgage, it might be diffi cult to get the money back again. The key is to think about what access to your savings you might need in future.
“Most deals will not have the flexibility to allow the borrower to draw back on previous overpayments,” says David Hollingworth of broker London & County.
“It’s important not to throw every spare penny at overpaying the mortgage, as you should keep a rainy-day savings fund. An offset could prove a good solution as it essentially provides the same benefits of overpaying but without sacrificing easy access to the cash.”
Offset deals are tax-efficient
With an offset, you are effectively earning the mortgage rate on your cash. However, as you are reducing the interest charge – rather than earning interest – there is no tax to pay.
“Although the personal savings allowance enables savers to earn some interest without paying tax, this can still be of real benefi t,” says Mr Hollingworth. “For example, a borrower offsetting cash against a mortgage with a rate of 3%, say, would need to earn a gross savings rate of 3.75% as a basic-rate taxpayer, rising to 5% as a higher-rate taxpayer – and 5.45% as an additional-rate taxpayer.”
Higher interest rates
While all of this may sound appealing, the downside of an offset mortgage is that rates are likely to be higher than other less fl exible mortgages. Ryan Tuff, a senior adviser at online broker Trussle, says: “While an offset means you can access your savings at any time, you will typically end up paying a higher rate of interest for the privilege of having this flexibility.”
Shaun Church, associate director at broker Private Finance, agrees: “Many offset mortgages carry an additional charge, which can be larger than the amount of mortgage interest borrowers with modest savings are able to offset.”
When it comes to offsetting, high-net-worth individuals and self-employed borrowers stand to benefit the most, as they tend to have signifi cant savings or are typically locked out from the best mortgage deals; this type of deal may suit also those who receive bonuses.
Equally, with returns on cash savings at rock bottom right now, offset could increasingly appeal to a broader range of borrower, including those with a small savings pot, who save into it regularly. This is especially true now the premium for taking an offset has decreased, meaning an offset deal is no longer signifi cantly more expensive.
Mr Murphy says: “If you want the fl exibility of having savings available, yet the ability to make those same savings work harder by reducing the monthly mortgage payment – or term of the mortgage – an offset could be an option that offers the best of both worlds.”
As a borrower, it can be hard working out what products may be suitable for you, what fees may be applicable, and what level of savings – and equity in your property – you would need to be considered for an offset in the fi rst place. If you are struggling, it is worth seeking professional help from a broker or independent financial adviser who can help weigh up all the options available to you.
“I used an offset mortgage to reduce my loan by 10 years”
Simon Luckings from Bury St Edmunds (pictured above) recently opted for an offset mortgage to make his savings work harder for him in the low-interest rate environment.
The 30-year-old, who manages his family’s commercial landscaping business, bought his first home, aged 20, with the help of his parents.
“At the time, I took out a mortgage with Santander with a 35-year term,” says Simon. “My aim was to have the lowest monthly repayments possible.”
However, after splitting up with the girlfriend whom he had been living with at the time, he then rented out his property. “At that stage, the monthly payments were around £700, but as the rent covered my mortgage, there was no impetus for me to change the deal I was on,” he says. “But when I moved back into the property with my current girlfriend in October 2015, I had a bit of a shock at the cost of the repayments. This motivated me to shop around for a better deal.”
Simon is now on a two-year fi x offset with the Yorkshire Building Society (YBS) at 1.39%. “As I already had some savings with YBS, an offset made sense – as this meant I was putting my money to better use when savings rates are so low,” says Simon. “I was able to secure a very competitive deal, which left me a lot better off financially. This mortgage has also enabled me to reduce the term of my loan by 10 years – from 27 years down to 17 years. Better still, if I maintain the level of savings I currently have, the term could reduce
even further to just 14 years – meaning I could potentially have paid off my mortgage while in my 40s.”
Current best buy offset mortgage deals
If you are looking to offset, cheap two-year fixes currently available at 60% loan-to-value (LTV) include Scottish Widows Bank at 1.35% with a £1,499 fee and First Direct at 1.59% with a £1,450 fee.
Cheap two-year fixes available at 75% LTV include Scottish Widows Bank at 1.49% with a £1,499 fee, and Yorkshire Building Society at 1.52% with a £1,495 fee.
At 90% LTV, Yorkshire Building Society has an offset at 2.29% with a £995 fee and also has an offset at 95% LTV at 3.59% with a £995 fee. Rates are correct as of 11 January 2017. Source: Moneyfacts and London & Country