Peak opportunity to pay down mortgage debt

THEY are most strongly associated with the property boom years, but offset mortgages are making a comeback as low interest rates, high inflation and increased competition among lenders combine to boost the appeal of the deals.

Offset mortgages work by using funds held on deposit or in a current account to pay down the mortgage. The money is set against the mortgage to reduce the interest at the prevailing rate, with none of the tax that is paid on interest earned on taxable savings.

The actual returns from offsetting are lower than they used to be, as loan repayment rates are low. But with the gap between the interest rate on savings accounts and that on mortgages often wide, the effective returns can be far better.

Their peak came in the mid-noughties, with then HBOS-owned Intelligent Finance leading the way until the credit crunch pulled the rug from under the market. There are still almost 500,000 borrowers on offset mortgages, which are growing in popularity once more as inflation continues to ravage the income paid by conventional savings accounts.

Lorraine O'Shea, director at Honour Financial Planning in Edinburgh, said: "In the current climate, reducing mortgage debt whilst interest rates are so low is an opportunity that is too good to miss.

"While we know the government wants us to spend the extra disposable income on the high street, in reality the savvy are using the excess income caused by low interest rates to deleverage their own personal balance sheets."

New figures show that homeowners with offset mortgages have made an effective total return of 1.9 billion over the past two years, compared with the 534 million in net interest they would have received from the equivalent investment in the "best buy" savings accounts.

The research, by First Direct, found that the average offset savings balance has risen by 19 per cent since the second half of 2009. The average total loan balance has risen by just 2.5 per cent over the same period, to 130,186.

The average offset saving balance is now 26 per cent of the mortgage balance, up from 22 per cent two years ago.

Richard Tolchard, senior mortgage product manager at First Direct, said: "While many UK savers are currently seeing the value of their savings eaten up by inflation as well as being taxed on the interest earned on these savings, no tax applies if they use their funds to reduce their mortgage balance."

The main attraction of offsetting in the current market is the combination of being able to pay down a loan while protecting savings from the effects of inflation.

And with interest rates unlikely to rise before next year, more borrowers reaching the end of their existing deals are casting a glance at offset loans.

Melanie Bien, director of mortgage broker Private Finance, said: "This will enable them to clear their mortgage more quickly and pay less interest in the long run, while retaining access to their savings in case of emergency – such as job loss."

That doesn't mean they make sense for everyone however, whether buying a home for the first time or coming up to the end of an existing mortgage deal.

Borrowers most likely to benefit from offsetting are those with a large amount of money on deposit or a consistently positive bank balance. In short, the more money with which to offset against your mortgage balance, the better.

Bien said: "In an ideal world, you would have as much in savings as you owe on your mortgage, which would mean you would not pay any interest, while still retaining access to your savings in case of emergency."

Those who are self-employed and others with cash on deposit that they intend to use to pay off costs such as annual tax bills could also find offsets effective.

"They can put aside an amount every week into an offset account to comfortably build up enough to pay the tax bill every six months," O'Shea explained. "During this period, the money in the offset account makes the mortgage balance shrink faster. This will knock several years off the mortgage, and save thousands in future interest payments."

Higher rate taxpayers liable for a large tax bill on their savings (except in individual savings accounts) also stand to gain from offsetting. "Currently, a higher rate taxpayer is lucky to get 3 per cent gross on cash savings, which after 40 per cent tax is a net return of just 1.8 per cent," said O'Shea. "So, in most cases the mortgage rate payable is far higher than the net return that can be made on cash."

It's not as easy to find a decent offset mortgage as it used to be, however, following the post-crunch shrinking of the mortgage market, so shopping around is essential.

The good news is that repayment costs have fallen to a similar extent to those on conventional mortgages, particularly for those with a certain amount of equity under their belts.

"As rates have fallen, and are similar to non-offset deals, having huge amounts of savings to make it worthwhile is not as much of an issue as in the past. But the more you have in savings, the bigger the benefits," said Bien.

The main providers include Yorkshire Building Society, First Direct and the Woolwich. First Direct currently has a two-year rate of 2.29 per cent (the bank base rate of 0.5 per cent plus 1.79 per cent). However it's only offered to borrowers with at least a 35 per cent deposit or equity, and comes with a 1,499 fee.

The Yorkshire's range includes a five-year fix at 4.09 per cent, for borrowers with a 25 per cent deposit or equity, and a tracker at the base rate plus 2.59 per cent, requiring at least 15 per cent equity or deposit.

But even if you don't have a large savings pot, it's worth comparing offset deals to conventional deals, particularly if you have enough of a deposit or equity in your home to get one of the more competitive loans.

While the First Direct deal ranks with the lowest cost mortgages around, others are marginally more expensive, so there's a balance to be found between the amount saved by getting a cheaper mortgage and the money that can be saved through an offset arrangement. If the rate of interest on an offset mortgage is higher than on a conventional deal, and you have no savings or surplus income with which to offset the loan, there's no benefit in paying a higher mortgage rate of interest.

There's also less mortgage choice generally, said O'Shea. "Offset fixed rates aren't as common as offset variable rate and usually shorter term, maybe two years, so if you really want security in terms of the rate, then an offset may not be the right choice.

"That said, if someone really works at using the offsetting features, they can reduce the effective mortgage rate charged substantially."