Offset your mortgage and save £42,000

Do you want to combat appallingly low savings rates? An offset mortgage could be the answer.

Have you ever considered offsetting your  saving against your mortgage?

According to mortgage lender, First Direct, savings that are offset in this way work more than ten times harder than savings that are kept in an easy access savings account.

Haven't a clue what I'm talking about? For the uninitiated, an offset mortgage enables you to use your savings to reduce the amount of interest you pay on your mortgage debt.

For example, if you have an outstanding mortgage of £150,000 and savings of £30,000, you’ll only pay interest on the balance - ie a mortgage of £120,000. But you still retain access to your cash cushion if you need it further down the line.

Unfortunately, you won’t earn any interest on your savings while they are offset against your mortgage, but the reduction in your overall mortgage interest bill could more than compensate. The table below from First Direct demonstrates this point:

Interest saved with an offset mortgage

Source: First Direct. Figures are rounded to the nearest pound.

First things first: bear in mind the figures in this table don't show what would happen if you got one of the most competitive savings accounts, which pay around 3% at the moment. The rate of interest used in these figures is just 0.23% AER which might seem rather low, but this is the average return earned by UK households on easy access savings according to the Bank of England. Shocking, perhaps, but be honest now - when was the last time you checked how much your savings were earning? Believe it or not, 0.23% is probably not too far off the mark!

So, while the interest rate on savings is low, I don't think First Direct is making an unreasonable comparison.

It’s also assumed that you own a property worth £250,000 with a mortgage of £150,000 repayable over a 25-year term. The mortgage is a lifetime offset tracker at 2.09% above the base rate giving a current pay rate of 2.59%. This isn't a made-up deal - it's one that is currently available from First Direct (no coincidence, I'm sure).

The figures reveal that a borrower with £100,000 in savings could be more than £42,000 better off by offsetting over a 25-year mortgage term. Looking at that in more detail, £100,000 worth of savings might otherwise earn just over £5,900 in interest over the same period. But the amount of interest saved by offsetting £100,000 against your mortgage loan runs to more than £48,000 - that’s equivalent to a net saving of £42,100.

There’s no question £100,000 is a pretty hefty to sum to have going spare without any of it being earmarked for spending elsewhere. But, when savings rates are as low as they are today, offsetting will invariably be beneficial no matter how much you have in spare cash. As a general rule, if your mortgage interest rate is higher than the return you can earn on your savings, offsetting will make good financial sense.

Offsetting can save interest even if you have a relatively low level of savings. Just £1,000 used in an offset facility can equal net savings of almost £600 compared with putting this same amount away in an instant access savings account. Meanwhile, a £10,000 lump sum can lead to a net interest saving of £5,789.

Do offsets really offer good value?

This all looks rather convincing, but is offsetting a decent choice for you? After all, offsets are often criticised for charging higher rates than standard home loans. So, could the benefits be wiped out by more costly monthly repayments? The tables below shows the top offset mortgages with variable rates and fixed rates over two years:

Top variable rate offset mortgages (ordered by true cost over two years)

Source: Moneyfacts

The deals have been ordered by true cost over a two-year period. This takes into account the total cost of the loan including the monthly repayments as well as extra costs for setting the mortgage up, such as the product fee, valuation fee and an estimate for legal costs.

The figures are based on a property value of £200,000 and a mortgage loan of £120,000 over a 25-year term. This gives a loan-to-value of 60% which represents the mortgage as a percentage of the property value.

As you can see First Direct is offering the most competitive deal right now with a best buy two-year offset tracker at BBR + 1.89%, giving a current rate of 2.39%. But with a true cost over two years of £13,040, how does it compare to the best non-offset deal?

The cheapest ordinary variable rate - again by true cost over two years - is from NatWest/Royal Bank of Scotland which offers a fee-free two-year tracker deal at BBR + 1.79%, with a current pay rate of 2.29%. This time the true cost is £422 cheaper than the First Direct deal at £12,618.

It’s true the best offset mortgages are a little more expensive, but given the interest savings you could make over the term, I think these deals look pretty competitive at the moment even with the slightly higher monthly repayments.

Don’t forget, these deals are only available to borrowers who can meet the loan-to-value requirements. The top offsets, and indeed any best-buy mortgage deals, require you to put down a pretty hefty deposit or have a reasonably large amount of equity in your home.

Next let’s take a look at how the best buy two-year fixed offsets measure up:

Top two-year fixed rate offset mortgages (ordered by true cost over two years)

Source: Moneyfacts

First Direct also offers the best buy two-year fixed offset deal with a rate of 3.19% and an ultra low product fee of just £99. But once again it has been pipped to the post by the top non-offset deal from NatWest/RBS with another fee-free deal offering a rate of just 2.75%.

The true cost of the NatWest/RBS deal over two years is £13,286, which is £937 cheaper than First Direct at £14,223. That said, the most competitive fixed offsets could work out more cost effective if you have a reasonable amount of savings of say, more than a £1,000 or so put into an offset facility.

There’s certainly a strong case for choosing to offset in the current low interest environment. Better still, lenders will allow you to claw your savings back if you need the cash for other purposes. But remember, to make them most of offsetting you should devote the greatest proportion of your savings to it as you can afford.

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* Source: Bank of England - Monthly interest rate, as at 31/08/10, of UK monetary financial institutions (excl. Central Bank) sterling instant access deposits from households not seasonally adjusted (unrestricted withdrawals) (working: savings balance x 0.23% AER compounded over 25years).

**Based on borrowing £150,000 against a property worth £250000 over 25 years showing the reduction in total cost of the mortgage when the savings amounts are offset against First Direct’s 65% LTV Lifetime offset tracker mortgage, tracking 2.09% above the Bank of England Base Rate (currently 2.59%).

At lovemoney.com, you can research all the best deals yourself using our online mortgage service, or speak directly to a whole-of-market, fee-free lovemoney.com broker. Call 0800 804 8045 or email mortgages@lovemoney.com for more help.

This article aims to give information, not advice. Always do your own research and/or seek out advice from an FSA-regulated broker (such as one of our brokers here at lovemoney.com), before acting on anything contained in this article. 

Finally, we tend to only give the initial rate of a deal in our articles, but any deal which lasts for a shorter period than your mortgage term may revert to the lender's standard variable rate or a tracker rate when the deal ends. Before you take out a deal, you should always try to find out from your lender what its standard variable rate is and how it will be determined in the future. Make sure you take all this information into account when comparing different deals.

Your home or property may be repossessed if you do not keep up repayments on your mortgage.