The forgotten costs of an offset mortgage

On the surface, using offset mortgages appear to be far better than savings accounts, but this is not always the case.

On the surface, using offset mortgages appear to be far better than savings accounts, but this is not always the case.

How the banks always win

Give up your savings interest and you'll be richer. That's the basic premise behind offset mortgages.

It frequently makes sense to pay off a debt at 3% before earning savings interest at 3%, because savings interest is usually taxed, reducing the benefit.

To make things worse for people juggling both loans and savings, the interest rate we pay on our debts is usually higher than the interest we get on our savings. That's a part of how banks make money.

Altogether, this means we will usually pay more interest than we earn.

Here's a solution

An offset mortgage can be a solution to this problem. Instead of earning interest in a savings account, you offset your savings against your mortgage. You can still take out those savings whenever you like but, while they're offsetting the mortgage, they reduce the outstanding debt, which in turn reduces the interest you pay each month.

Your monthly repayments also come down, so it can be sensible to overpay by saving the difference in the offset to reduce your overall mortgage costs.

It's not that simple

Unfortunately, offset mortgages usually come with higher interest rates than other mortgages. This puts a spanner in the works that reduces the likelihood that an offset will be right for you.

Before I get to today's best offset, let's look at an alternative “normal” two-year tracker deal. First Direct has one of the cheapest ones. There are several very similar mortgages of a similar price that may suit you better, such as from Yorkshire Building Society or Nationwide, but I'll take that one anyway.

The First Direct two-year (non-offset) tracker mortgage charges 2.69% with no arrangement fee, although you'll have to pay £150 to get out of the deal at the end. To get this mortgage, the loan amount must be less than two-thirds of the current price of your home.

Taking into account all the mortgage's fees and charges (assuming you switch at the end of the deal), a £100,000 mortgage with 15 years remaining could cost you £16,370 over two years. At that point, your mortgage outstanding will be reduced to £88,880.

Going now to the cheapest two-year offset tracker mortgage, which is from First Direct again, it is a little more expensive at 2.99% with no fees. Since you have offset £10,000, you could pay lower monthly repayments, but let's say you decide to pay at the same monthly rate as the other mortgage to pay off your debt faster. This means you will have paid £16,220 after two years. (That's a little less still due to the other mortgage's admin fees.)

Since you have offset savings and been able to overpay at no extra cost, you have paid less interest and paid off more of your mortgage, so your outstanding balance is now down to £78,850.

Our story doesn't end there

So far we have paid a similar amount in our two examples: the simple tracker mortgage has cost £16,370 and the offset mortgage slightly less at £16,220, because you have sensibly taken the opportunity to overpay.

However, with the simple tracker there is still about £88,880 outstanding on the mortgage, whereas there is just £78,850 on the offset.

That difference may sound huge, but I hope you haven't forgotten the £10,000 of savings. This has already been taken into account on the offset mortgage, but if you bought the simple tracker you will presumably have been earning interest on your savings elsewhere. Currently the best easy-access account pays 3.1%. Assuming you can maintain that rate for two years, perhaps by switching in 12 months' time, a higher-rate taxpayer could build a savings pot worth £10,375.

Here's how the two deals compare now:

So, in this example, the offset mortgage would have left you about £200 worse off, due to a combination of a higher mortgage interest rate and no savings interest earned.

Things to consider

1. If you or your partner have a lower income tax rate, or if you put money into ISAs, you could be another few hundred pounds better off with the simple tracker than shown above.

2. On the other hand, if you have a larger savings pot it becomes harder to save tax-free, especially if you haven't been filling up your cash ISAs over the years. Also, greater savings thrown at an offset puts the maths more in its favour. The larger your savings pot, the more likely you are to benefit from an offset.

3. Most articles covering offset mortgages just compare the interest you'd save on the offset with the interest you'd earn in a savings account after tax. However, often what's even more important is the difference between the interest rate you pay on the offset and the interest rate you could pay on a different mortgage. I think this is the most important point that many people overlook when buying an offset mortgage, and yet it is demonstrated in my example above.

4. My example might not – and probably doesn't – apply to your exact situation, but it should help show the other side to offsets, since many publications have written so favourably about them recently. Whether to get an offset will depend on the size of your mortgage and savings, which products you'd be accepted for, what length and type of deal suits you, and whether you decide to overpay.

5. There are a few other little pros and cons to offsets, some related more to convenience and service than moneyIf you have any questions about them, why not see if a fellow reader has the answer in our Q&A section, or discuss them with lovemoney.com's mortgage team, if you're looking for a new mortgage.

6. Since I'm not a prophet, my example is based on the huge assumption that interest rates won't move for another two years. As rates rise it could get easier to win with an offset, because the tax you'll pay on savings will go up.

That said, if you pay no tax on most of your savings, all things being equal, it shouldn't matter what happens to interest rates. But if things aren't equal and mortgage tracker rates were to rise faster than the best savings rates, say, that might swing the advantage over to an offset. Pity we can't read the future.

7. A long-term fixed interest deal – especially at today's prices – could turn out better than any other option if rates go up fast in the next few years, and stay there. Plus they have fewer risks. Consider a five- to ten-year fix as an alternative to offset or cheap variable deals.

More: Compare mortgages through lovemoney.com | Interest rates to stay unchanged until 2012 | Most affordable property in eight years

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