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, leaving over a million homeowners facing higher monthly payments this year when their existing fixed deal comes to an end. 

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

We take look at how this type of home loan works, and who might benefit the most from using it. 

Offset the interest: Offset mortgages allow you to utilise your savings to reduce the amount of interest payable on your loan

What is an offset mortgage? 

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

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

Depending on which bank you are with, you might be able to have a few different accounts to draw from.

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

The money in your savings account won’t earn any interest, but it reduces the interest you pay on your mortgage – potentially saving you thousands over the lifespan of the loan. 

Your savings will not reduce over time, and can be accessed at any point. 

What are the benefits of using an offset mortgage?

The most obvious benefit is the savings you make by paying a reduced amount of interest.

Hina Bhudia, partner at Knight Frank Finance, says this kind of mortgage can work well for ‘people that are self-employed, and those that are typically saving throughout the year to pay their tax as a lump sum’. 

‘It works for people that have cash saved, but that cash is not working for them or is locked away,’ she adds. 

‘Ultimately, if people have any surplus cash, it can be used to reduce the interest they pay on their mortgage repayments.’

Offset mortgages benefit those with large amounts in savings that can be used against their loan tax-free

Offset mortgages benefit those with large amounts in savings that can be used against their loan tax-free

Opting for an offset mortgage could also be advantageous for higher taxpayers with large savings balances. This is because you don’t pay tax on the savings, as you are reducing the debt instead of earning interest.

‘It could work for someone that has raised money for something like a home improvement project or even for school fees, where the funds will not all be required at first,’ adds L&C’s David Hollingworth. 

‘They can be offset against the mortgage to avoid a higher interest charge until the funds are needed.’

What are the downsides of an offset mortgage? 

‘If it sounds too good to be true this is partially right. The privilege of an offset account is it often comes with higher rates compared to standard mortgages,’ says Nicholas Mendes at John Charcol.

If you withdraw any savings, you risk paying a higher rate on a larger proportion of the loan, effectively losing the cost savings.

So while you have total flexibility over whether you leave your savings in the offsetting account or use them elsewhere, what you do will impact your mortgage payments. 

You also need to consider that you will not be earning interest on your savings for the duration of the loan.

‘If you feel you might need to draw from the savings, you will need to weigh up if it is better to take a traditional mortgage or if an offset works best. A good broker will be able to assist with this,’ says Bhudia.

What are the rates on offset mortgages? 

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

‘Whilst the rate is higher, if you have savings which are not generating a return equivalent to that of your mortgage rate after tax, then it’s still worth considering an offset product,’ says Bhudia.

Another issue customers may encounter is availability of these products. 

There are currently 4,372 residential mortgage products available, but only 78 offset products on offer, down from 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 comparable deal at 4.77 per cent for a 40 per cent deposit.

 Why did mortgage rates go up?

Mortgage rates first began to increase in December 2021, when the Bank of England began putting up its base rate to try and combat rising inflation.

However, this accelerated after the mini-Budget in late September. The pound tumbled after the then-Chancellor, Kwasi Kwarteng, announced several tax cuts that appeared to be unfunded.

UK borrowing costs jumped as investors sold off their UK Government bonds – known as gilts – before the Bank of England stepped in announcing a £65billion programme of buying bonds to shore up the market.

Up again: After falling gradually since January, swap rates are now climbing again and will impact fixed rate mortgages

Up again: After falling gradually since January, swap rates are now climbing again and will impact fixed rate mortgages

After former Prime Minister Liz Truss resigned in October and new Chancellor Jeremy Hunt reversed nearly all of the mini-Budget announcements, the markets calmed down and the cost of borrowing has fallen with mortgage rates slowly dropping too.

However, it is worth keeping an eye on prices as swap rates, the financial metrics on which most lenders base their mortgage prices, are ticking back up.

Swap rates are an agreement between banks where they exchange a stream of future fixed interest payments for another stream of variable ones, based on a set price.

They tend to show where the markets think mortgage rates are headed in the longer term and are factored in to home loan prices.