Offset mortgages and how they work

Offset mortgages can be attractive for borrowers who have spare cash that they want to hang on to, perhaps because of continuing job uncertainty, but which is not earning them much interest because of low savings rates.

This type of mortgage allows homeowners to use their savings to reduce monthly loan costs while keeping full access to their spare money — and to effectively earn an interest rate of 4.6 per cent when most savings accounts are paying one per cent or even less.

How do they work? As well as taking out a mortgage, you have a separate savings account — and sometimes a current account — with the bank that has lent you the mortgage.

Instead of receiving interest, these linked accounts reduce the interest you pay on the mortgage. The account balance is subtracted from the mortgage debt figure, with loan interest only charged on the net difference. For example, if the mortgage is £100,000 and you have savings of £20,000, you only pay loan interest on the £80,000 difference. If you then decide to withdraw £10,000 of savings, you pay mortgage interest on £90,000.

Are they good? In effect, you earn the mortgage rate on the savings you keep with the lender. And because you aren’t actually given this interest, there is no tax to pay.

According to First Direct, a leading provider of offset mortgages, the average homeowner earns 4.6 per cent on savings linked to these mortgages.

However, offset loan rates can be higher than those on conventional mortgages. Offsets therefore make most sense for borrowers with significant savings, particularly for higher-rate taxpayers who would otherwise lose 40 per cent of their interest in taxable accounts. Self-employed people with large amounts of cash sitting in their accounts at various times of the month also stand to benefit.

And current accounts? These use the offset principle as well but put your credit and debit balances in one pot, rather than keeping them separate. This means you are constantly in the red, and some experts think traditional offsets are easier to manage.