With traditional mortgages, you take out a loan from the bank and you make monthly payments which either pay of the interest and a portion of the capital (repayment mortgages) or simply cover the interest with the capital being repaid at the end of the loan period (interest-only mortgages). Then there are offset mortgages, which work rather differently.
The mechanics of offset mortgages
With an offset mortgage, you put as much money as you can into your mortgage account each month thus reducing the balance of the loan as far as possible and thereby minimising the amount of interest you pay on it. Should you need to, you can choose to withdraw some of this money at a later date, accepting that this will increase the outstanding balance on the mortgage and hence the amount of interest payable on it. The basic idea behind offset mortgages is that financial institutions typically pay less in interest to savers than they charge in interest to borrowers, which means that, other than having cash available for emergencies, there is very little value in having savings if you also have debt, because the interest you earn on the former will be less than the interest you pay on the latter. That being so, it makes more sense just to put all your spare funds towards paying off your debt.
The case for offset mortgages
Unless you can find a savings or investment product which can earn you better returns than you would get from simply reducing the interest payments on your mortgage, then from a purely mathematical perspective, offset mortgages can make a lot of sense, even in a low-interest-rate environment. As interest-rates go up, the case for offset mortgages becomes even more compelling. This is because interest income is subject to tax, whereas interest payments on mortgages are unlikely to be tax deductible. The higher your income (and corresponding tax liability), the more attractive offset mortgages can be.
There are two groups of people for whom offset mortgages might be an especially suitable choice. The first group is the self-employed, who may be high earners but do not necessarily earn the same from one month to the next. Offset mortgages would allow them to make significant overpayments during high-earning months knowing that they would have the option to withdraw some of that money if they needed it later. The other group is buy-to-let landlords who can no longer claim mortgage interest tax relief and hence have a particular interest in minimising their mortgage interest expense.
The case against offset mortgages
There are three, main, potential drawbacks to offset mortgages. The first is that they require discipline. If you can’t trust yourself not to dip into your mortgage without a very good reason, then you might be better to go for the enforced discipline of a standard repayment mortgage.
The second is that offset mortgages are still very much niche products, which means that choice is relatively limited at this time. It remains to be seen whether or not this will change in the future.
The third is that some government schemes may require that you take out a repayment mortgage in order to qualify for them. Again, it remains to be seen whether or not this will apply into the future.
Offset mortgages are an interesting development in the mortgage market and may be excellent choices for some people, particularly higher earners. Lower earners, however, might feel more comfortable with the familiar security of repayment mortgages and keeping their cash and investments within an ISA wrapper for tax efficiency. As always, if you’re not sure what approach is right for you, it’s recommended to speak to a professional.
Your home may be repossessed if you do not keep up repayments on your mortgage.
The Financial Conduct Authority do not regulate buy to let mortgages.
Tax treatment varies according to individual circumstances and is subject to change.