Savings rates are languishing at rock bottom and with the looming spectre of negative interest rates, many will be wondering how to make the most out of their cash.
For those with large savings pots an offset mortgage could save them substantial amounts of money without the risk of investing.
An offset mortgage allows you to keep your savings with your mortgage lender and use the money to reduce how much interest you pay.
But could you really see big savings, or are there better ways to make use of your money?
For those with large savings pots an offset mortgage could save them substantial amounts
How does it work?
Offset mortgages link your savings and occasionally your current account to your mortgage.
This means that instead of earning interest on your savings, the cash in your account is offset against your loan balance, and you pay interest on the difference.
For example, if you had a mortgage of £200,000 and savings of £40,000, you would pay interest on £160,000 of your mortgage.
Some lenders let you reduce your monthly payments to reflect the smaller debt, reducing your monthly outgoings.
Alternatively, you can keep paying the same amount and pay off your loan quicker, as you’ll effectively be overpaying each month.
This doesn’t mean you won’t have access to your savings. You can access your money whenever you like, giving you more flexibility than if you had instead used the money to pay off a chunk of the loan.
The current average two-year fixed rate mortgage deal sits at 2.38 per cent. On a £200,000 mortgage, this would cost £1,048 a month over 20 years.
If £40,000 was offset against a savings account however, this would result in monthly repayments of just £839.
Over the life of the mortgage this would save the borrower over £10,000 in interest repayments.
This means you’d need to make a return of £10,000 over 20 years on a £40,000 investment to yield the same benefit.
To look at it another way, you’d need an annual return on your investment of around 1.12 per cent accounting for compound interest.
Alternatively, you could pay the same each month and pay your mortgage off five years early.
What about putting it in savings?
At the moment, with savings rates being so low, you’re unlikely to beat inflation by putting money in a savings account.
For example, the best easy access account currently on the market is Coventry Building Society’s Double Access account at 0.96 per cent.
Offset mortgages link your savings and occasionally your current account to your mortgage
Over 20 years, this would turn £40,000 into £48,422, earning a grand total of £8,422 interest.
If you were to take the best five-year fixed-rate savings account on the market, currently from Gatehouse Bank at 1.40 per cent, and reinvest along with the interest earned every five years (providing the same rate applied in five, 10 and 15 years), you would end up with £52,914 after 20 years, some £12,914 interest.
If five-year savings rates were to rise in the interim, that figure could go up.
Your options may be limited
Borrowers interested in an offset mortgage will find far less choice in deals than they would while searching for a normal mortgage.
They may also find that the rates on these deals are higher than on a normal loan.
The price difference has narrowed however to around 0.25 per cent,according to experts at Moneyfacts.
However, under this scenario the money would be locked away for five years, whereas with an easy access account or an offset mortgage it would be there for you to draw on should you need it.
There is also the tax paid on savings to consider.
Unless your savings are held in a cash Isa, you are liable to pay tax on any interest you earn from them over your personal savings allowance.
Since April 2016, if you’re a basic rate taxpayer you can earn up to £1,000 a year from in savings income tax-free. Higher rate taxpayers can earn up to £500.
Anything above this threshold will mean giving 20 or 40 per cent of your return to the taxman depending on your tax band.
With an offset mortgage, there isn’t any tax to be paid on the interest you save by using your savings to reduce the interest you pay on your mortgage.
Is investing a better option?
While it obviously comes with risks, investing the money can generate much better returns than the average savings account and be more beneficial in the long run than an offset mortgage.
This is Money asked experts at AJ Bell, to see how various funds and trusts would have performed had you invested £40,000 in the year 2000:
- FTSE All Share: £86,498
- F&C Investment Trust: £155,150
- Scottish Widows UK All Share Tracker fund: £82,687
What would have happened if you invested £40,000 in the year 2000?
All options are much more appealing than the £10,000 saved by an offset mortgage.
While looking backwards is no guarantee of the future potential of an investment, it does help give some perspective.
But as with a fixed rate savings account, the offset mortgage has the advantage of keeping your wealth liquid should you need to draw on it.
And as stated above, there is no risk involved when offsetting a mortgage.
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