Offset mortgages: How do they work and is linking savings to your home loan a good idea?

Mortgage rates have risen sharply over the past six months, leading more than a million homeowners to face higher monthly payments this year when their existing permanent contract ends.

For those with significant savings in the bank, an offset mortgage can be one way to reduce those costs.

We look at how this type of home loan works and who benefits most from it.

What is a bridging mortgage?

An exchange mortgage essentially links your savings account, or in some cases your checking account, to your mortgage with the same bank.

When you make a payment on your mortgage, the amount is ‘offset’ by the balance in your savings account and interest is calculated on the difference between the two.

Depending on which bank you are with, you may be able to have a number of different accounts to withdraw money from.

For example, if you had a $200,000 mortgage and $20,000 in your linked savings account, you would only pay interest on $180,000 of the mortgage. This can save you thousands in interest over the life of the loan.

The money in your savings account doesn’t earn interest, but it reduces the interest you pay on your mortgage — potentially saving you thousands over the life of the loan.

Your savings will not diminish over time and can be accessed at any time.

What are the benefits of using an offset mortgage?

The most obvious benefit is the savings you make by paying less interest.

Hina Bhudia, a partner at Knight Frank Finance, says this type of mortgage can work well for “the self-employed and those who typically save year-round to pay their taxes all at once.”

“It works for people who have money saved, but that money doesn’t work for them or is locked up,” she adds.

‘If people eventually have money left over, they can use it to pay off the interest they pay on their mortgage.’

Opting for a set-off mortgage can also be advantageous for higher taxpayers with large savings. You do not pay tax on the savings, because you reduce the debt instead of earning interest.

“It could work for someone who has raised money for something like a home improvement project or even school fees, where the money won’t all be needed initially,” adds David Hollingworth of L&C.

“They can be offset against the mortgage to avoid higher interest charges until the money is needed.”

What are the disadvantages of a bridging mortgage?

“If it sounds too good to be true, it’s partially right. The advantage of a contra account is that it often has higher rates compared to standard mortgages,” says John Charcol’s Nicholas Mendes.

If you withdraw savings, you risk paying a higher interest rate on a larger portion of the loan, effectively forfeiting the cost savings.

So while you have total flexibility in determining whether to leave your savings in the offset account or use them elsewhere, what you do will affect your mortgage payments.

You should also bear in mind that you will not receive interest on your savings during the term of the loan.

“If you feel you need to tap into savings, you need to weigh up whether it’s better to take out a traditional mortgage or whether an offset will work best.” A good broker can help with that,’ says Bhudia.

What are the rates for mortgage interest deduction?

Currently, the average rate on an offset mortgage is 5.45 percent, compared to the two-year market average of 5.32 percent and the five-year average rate of 5 percent.

“Although the rate is higher, it’s still worth considering a compensation product if you have savings that don’t yield returns equal to your after-tax mortgage interest,” Bhudia says.

Another problem that customers may encounter is the availability of these products.

There are currently 4,372 residential mortgage products available, but only 78 compensation products are offered, compared to 88 at the same time last year.

Coventry Building Society is currently offering a five-year fixed deal at 4.71 per cent with a minimum deposit of 25 per cent. Accord has a similar deal at 4.77 percent for a 40 percent down payment.