Essentially, you have a savings account linked to your mortgage account, but instead of earning interest on your savings, your money is used to "reduce" the balance of your mortgage. So if you had a £100,000 mortgage with £10,000 in the savings account, you would only accrue interest on the £90,000 portion. There is also a tax advantage to offset mortgages particularly if you pay a higher rate taxpayer, as you don't pay any tax on the reduced interest you pay. So, rather than receiving, say, 3% on your savings after tax, you can actually save interest of 6% on your mortgage.
Putting this into a simple example, £10,000 in an account paying 5%AER would earn £500 in gross interest over a year - £400 for a lower rate taxpayer and £300 for a higher rate. Over 10 years a lower rate taxpayer would make £4,802 and a higher rate £3,439.
At the same time, a £100,000, 10-year mortgage at 6% would accrue £33,224 in interest. By using that £10,000 to offset the loan (and effectively make it £90,000) you would accrue £19,902 in interest, a whopping £13,322 less. So although a higher rate taxpayer would have sacrificed £3,349 in interest on his savings, he would have saved nearly four times this amount on his mortgage.
Of course, he would need to leave his £10,000 untouched in the account for ten years. Offset mortgages can clearly be a good option for anyone with a hefty amount of cash stashed away. As a rule of thumb, to make a real difference you need around £10k in savings for every £100k mortgage debt. However, smaller amounts can make a real difference, too.
Offset mortgages can also be particularly good for people who are self-employed, or receive hefty annual bonuses. By putting money that's been set aside for tax purposes into an offset savings account, self-employed homeowners can benefit from their cash working against their mortgage debt. And paying in annual bonuses can make a substantial difference.
Unfortunately, offset mortgage rates have tended to be far from competitive in the past, with rates of one per cent or more than the best fixed rate mortgage deal. However as they become more wide spread we could well see the interest rates on offset mortgages coming down.
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