Becoming debt-free with an offset mortgage

Getting rid of your mortgage early and becoming debt-free has become a key ambition of many people, and has even spawned television series such as 'Pay off your mortgage in two years'. While most ordinary folks may find meeting even their minimum home loan repayments a bit of a struggle (and paying off a mortgage in just two years might appear to be a TV producer's gimmick, rather than an achievable objective for most families) it certainly is possible to repay your mortgage more quickly than the agreed term. And contrary to what the TV pundits may tell you, you dont have to drive a cab at weekends or give up your morning latte to do it.

Debt-free drive

According to research by mortgage lender Intelligent Finance, nearly three-quarters of borrowers would reduce their mortgage term, or increase their mortgage payments to reduce the balance over time. One in five would welcome being able to lower the amount on their regular mortgage payment. But isn't that easier said than done?

How do these mortgages work?

One of the easiest and most 'pain-free' ways to pay off your home loan early is to opt for an offset or current account mortgage. This type of arrangement gives you a loan to buy your house on the one hand, and either a savings account or bank current account on the other, and cleverly links the two. The system works by effectively giving you no interest on your savings, and instead carrying the notional amount that you would have received if the savings account had been the traditional kind, and offsetting it against - or deducting it from - interest due on your loan. This has the effect of either reducing the monthly payments due, or, if you maintain the monthly payments at a level rate, decreasing the term of the loan, allowing you to pay it off early.

How is an offset beneficial?

But why would anyone do this? If you had that much in savings, why not simply have a smaller mortgage? Well, there are a number of reasons. The first is that everyone needs a rainy day fund. How much you need will depend on how much you might get paid if you lost your job, and how much insurance would pay out in case of various disasters. But you should certainly keep enough readily available to cover emergencies, such as renting a car after an accident in your own or getting repairs done to your roof after a storm before the insurance pays out - or any other unexpected expense.

Normally you would put this rainy day fund in a savings account, but you would usually pay tax on the interest you receive. This is as high as 40% if you were a higher rate taxpayer. By offsetting the notional interest against your home loan you are effectively receiving the interest tax-free.

What if I have no savings at all?

In this case a current account mortgage might suit you. Accounts such as the One account, which combine your mortgage and cheque account, operate like a huge overdraft. Each month, as your salary hits the account, it reduces the mortgage loan overdraft, which gradually climbs up again as the month goes by and your other monthly living expenses go out. However, instead of having your wages sitting in an ordinary high street cheque account, earning as little as 0.01% taxed, and the mortgage debt accruing at its agreed rate, the money from your salary is once again working to reduce your mortgage debt and earning the interest rate of the loan.

Flexibility

You can often choose the effect that offsetting will have on your mortgage loan. More sophisticated offset products let you choose whether you want a shorter term, lower payments or reduced debt. Some providers also let you offset against an individual savings account so there will be no tax savings there, as ISAs are already tax-free. But interest rates are often higher on cash ISAs than on ordinary savings accounts, and, if you are anxious to maintain your annual ISA allowance, you can still do this and benefit from mortgage savings at the same time. Offset loans also allow borrowers to withdraw extra funds without having to remortgage, while lump sum overpayments to reduce the capital can be made without incurring a penalty.

Which borrowers suit offsets?

Data provider Defaqto says that, up to now, current account and offset mortgages have largely been favoured by people with higher incomes. However, providers are now looking to target a wider range of customers, as the existing market becomes saturated. Two groups of potential winners include buy-to-let investors, who use offset mortgages to hold savings balances to cover ongoing bills for maintenance, repairs and tax liabilities, and City workers with big bonuses who require greater flexibility.

13 April 2007 © Moneyextra.com

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