Do offset mortgages make sense for your pounds and pence?

An offset or current account mortgage is the ideal home loan repayment method for anyone who has large inflows of cash into their current account but does not want to lose access to it by using it to make irrevocable payments against the loan. If you need maintain access to the cash but would still like to use it to reduce the loan interest, then an offset is the answer.

Since their introduction to the UK market more than 20 years offsets have become increasingly popular. According to researcher Datamonitor, the current account and offset mortgage market was worth £29.2bn in 2004 and made up 10% of the total UK secured lending market. This is predicted to rise to £84.7bn by 2009, making up 30% of the total secured lending market.

It is not hard to see why they have become popular. The traditional way of keeping a loan and a rainy-day fund apart would be to have separate accounts, paying interest on the full amount of the loan and receiving a (usually) lower (and taxable) rate of interest on the savings.

Offset mortgages put savings and loan into a single account. Interest is then paid on the balance. So, someone who had a £250,000 loan and £5,000 of savings would be paying interest on just £245,000. If they needed to access some of the savings they could withdraw the amount they needed and would pay interest on the new higher balance. When they were able to make more savings they could use this to reduce the amount of the loan again. This means that offset accounts are particularly suited to people with commission-based income who receive bonuses, the self-employed who need to save up throughout the year to pay their tax bill, and employees who receive an annual bonus because they can use these lump sums against their loan.

Researcher Defaqto says that while most borrowers choose a mortgage on the basis of the lowest initial interest rate for the type of mortgage they want, the long-term advantages of an offset should not be ignored. Benefits include financial flexibility, tax efficiency, the potential shortening of the mortgage term, and avoidance of the cost and hassle of regularly remortgaging to get the best rates.

Overpay a little, save a lot!

Figures from Abbey show that borrowers with an offset mortgage who overpay by just £3 per day, could save themselves £22,000 in interest and pay off their mortgage three and a half years early. At the same time research from online bank Intelligent Finance found that one in three UK households looking for a new mortgage could save an average of £312 a year on their mortgage simply by taking an offset tracker 95 product with Intelligent Finance and moving their current account, direct access savings and ISAs to the bank.

Rachel Mckay, mortgage analyst at data provider Moneyfacts, says, "Offset mortgages provide consumers with the ability to manage their own repayment structure, permitting overpayments, underpayments and payment holidays, and with the possibility of a hassle-free additional drawdown facility. If managed correctly, consumers can soon see their mortgage term decrease.

"The ability to pool accounts, thereby reducing the interest accrued, can be very beneficial, particularly for the self-employed who save regularly for their tax bill. The interest on these savings would otherwise be taxed as additional income, but by offsetting these funds they work in the opposite manner, reducing the mortgage interest and thus not accruing any credit interest on which tax must be paid."

Refinements of the offset scheme include current account mortgages and family offset accounts. Current account loans, such as the One Account, lump not just mortgage and savings together, but mortgage and salary. The effect of having a wage payment hitting the account every month reduces the amount of interest paid over the lifetime of the mortgage dramatically, but borrowers need to be disciplined when they have their loan and income in the account they use for day-to-day spending.

Family offsets allow other family members, such as parents or grandparents, to pool savings with an offspring's home loan, making them potentially a good idea for first-time buyers, who may take advantage of funds held by an older generation who may have savings put aside. The "savings" elements are kept in a series of nominated accounts, so that the parent or grandparent keeps title to the capital but the interest is used to reduce the interest due on the loan. Savings can be drawn down at any time.

Among those providing family offsets are the Yorkshire, Leeds and Newcastle Building Societies. However, Woolwich has just discontinued its family offset scheme, citing lack of interest.

So what's the downside?

The usual criticism of offsets is the higher rate of interest that you pay to obtain the flexibility of an offset, but rates have been coming down and some offset rates are very competitive. Defaqto says, "The generally higher interest rates charged by offsets reduce the potential benefits, so that the borrower's level of savings and the tax status become crucial factors. Only average interest rates for offsets that track the base rate for the entire term of the mortgage offer lower rates than traditional mortgages."

Moneyfacts' Rachel Mckay says, "As the rates offered tend to be higher than those found on 'traditional' mortgage products, they can be an expensive choice if the consumer does not make full use of the offset features, and are best used as part of a long-term financial plan."

Defaqto says it is the affluent self-employed and higher-rate taxpayers who are most likely to benefit from offsets. It says that, provided the offset mortgage and saving rates trade-off at the industry average, offsets will be of particular value to borrowers who do not want to get involved in chasing the best saving rate or the cheapest mortgage.

David Black, head of banking at Defaqto, says, "If offset mortgages are approached as a fundamental part of the borrower's financial planning process, they can offer great benefits, both in terms of flexibility and in reducing the overall mortgage term.

"However, they are definitely products for the long haul, and should not be contemplated unless borrowers are fairly certain that they will be able to leave what can be significant sums of money more-or-less untouched in savings accounts over the mortgage term. Any permanent reduction in the size of the deposit, because of withdrawals, will result in the borrower paying above market rates for the extra mortgage needed to balance the withdrawn savings."

21 March 2006 © Moneyextra.com

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