Offset Mortgage vs. Savings: Which is the Better Choice?

In today’s unpredictable financial environment, homeowners who have both savings and a mortgage are carefully considering options that will give them the best return on their money. Two options that stand out are offset mortgages and traditional savings accounts. Both have unique advantages, but selecting the right option can make a significant difference to achieving one’s financial goals. This article explores what each option offers, and breaks down the benefits and potential drawbacks of each.

What is an Offset Mortgage?

An offset mortgage is a financial product that links your mortgage balance with a savings account (and sometimes even a current account). Under this arrangement, the balance in your savings account offsets the amount of debt on which you are charged interest. Instead of earning interest on your savings, you reduce the mortgage balance by the amount of your savings for the purposes of calculating the mortgage interest you pay, thus effectively lowering your monthly mortgage payments.

For example, if you have a £200,000 mortgage and £20,000 in savings, an offset mortgage allows you to pay mortgage interest on only £180,000 (£200,000 - £20,000 = £180,000). This can result in substantial mortgage interest savings, especially if mortgage interest rates are high. However, such mortgage interest savings should be compared with the foregone interest on the savings account to get a true picture of the net benefit. Offset mortgages are popular with homeowners looking for a more flexible way to manage their savings while reducing the interest cost of their debt.

Key Features of an Offset Mortgage:

• Reduces the mortgage balance on which interest is charged by the amount of the relevant savings balance.

• Provides potential for significant mortgage interest savings, especially during periods of high mortgage interest rates. Mortgage interest savings should be compared with the foregone interest on the savings account to provide a true picture, however.

• Allows more accessible use of savings than traditional mortgage overpayments, as savings remain liquid and can be accessed if needed.

How Do Traditional Savings Accounts Work?

A traditional savings account allows you to deposit money and earn interest on the savings balance. While these accounts typically offer low risk and consistent returns, they vary widely in terms of interest rates and access.

While easy access accounts usually provide immediate access to savings, other types of account provide access based on defined notice periods (for example, 90 days) and yet other accounts come with minimum fixed terms (ranging from a few months to a few years). Accounts requiring notice for access and those with longer fixed terms often offer higher interest rates compared to easy access accounts. The interest rate on savings accounts can, of course, fluctuate depending on the Bank of England’s base rate.

Key Features of Traditional Savings Accounts:

• Higher interest rates, than current accounts, although usually lower than mortgage interest rates.

• Compound interest, if the interest earned is not withdrawn.

• Certain accounts, such as ISAs, offer tax free on savings up to an annual limit, which is currently £20,000 for each tax year.

• Variable access to funds based on the type of account (for example, instant access accounts vs. fixed term deposits).

Offset Mortgages vs. Savings Accounts: Financial Pros and Cons

When deciding between an offset mortgage and a traditional savings account, it is essential to weigh the pros and cons of each option, particularly regarding interest savings, access and tax implications.

Advantages of Offset Mortgages:

• Interest Savings: Offset mortgages reduce the interest you pay on your mortgage by lowering the balance on which mortgage interest is calculated. For example, at a mortgage rate of 4%, offsetting the outstanding mortgage balance with savings of £20,000 would save £800 in mortgage interest each year. However, these mortgage interest savings should be reduced by the savings interest foregone on a savings account to get a true picture of the net benefit.

• Tax Efficiency: Offset mortgages can be tax efficient because savings in an offset account do not earn interest, meaning that there is no tax to pay on savings interest. This is particularly advantageous for higher rate taxpayers who could otherwise face significant tax on their savings interest.

• Flexibility: Offset mortgages allow borrowers to access their savings when needed, providing a level of liquidity and flexibility that traditional mortgage overpayments do not offer.

Disadvantages of Offset Mortgages:

• Lower Interest on Savings: Since savings are used to offset the mortgage rather than accrue interest, you forgo earning interest on the amount of savings in the offset account. This could be a disadvantage if savings accounts offer attractive interest rates compared to the mortgage interest rate.

• Slightly Higher Mortgage Rates: Offset mortgages tend to have higher mortgage interest rates than other, more standard mortgage products, which may reduce the effective financial benefit.

• Complexity: Offset mortgages require careful monitoring of both savings and mortgage balances. It is essential to understand how much you are saving and ensure that the benefits outweigh the costs.

Advantages of Traditional Savings Accounts:

• Interest Earnings: Savings accounts offer a predictable return, often compounding over time. Longer fixed term accounts and accounts with longer access notice periods can provide attractive interest rates.

• Simplicity and Variety: Traditional savings accounts are straightforward and come in various types, such as easy access, with notice periods, fixed terms and ISAs, allowing flexibility based on risk and time horizon.

• Tax Free Growth Potential: Tax free ISAs allow savers to benefit on up to £20,000 of savings annually without paying tax on the interest earned, ideal for building a tax efficient nest egg over time.

Disadvantages of Traditional Savings Accounts:

• Lower Real Returns: Interest from savings accounts may not keep up with inflation, reducing the purchasing power of your money over time.

• Potential Tax Liabilities: For those with larger balances, tax on savings interest above the personal savings allowance can impact returns, especially for higher rate taxpayers.

• Liquidity Trade-offs: Fixed term or higher interest accounts can lock your funds up for defined periods, which can limit your access to cash in an emergency.

Who Benefits Most from Offset Mortgages?

Offset mortgages can offer significant benefits to certain types of borrower, including:

• Higher rate taxpayers: Since offset savings do not earn interest, they avoid generating a tax liability, making this approach tax efficient for higher rate taxpayers.

• Self-employed or those with irregular income: An offset mortgage provides access to savings when needed, which can be a helpful cash management tool for those with fluctuating income.

• Homeowners with larger savings: Those with more substantial savings balances see greater benefits in offset mortgages, especially if mortgage interest rates exceed standard savings rates.

Tax Implications and Considerations

Offset mortgages offer potential tax advantages. For basic rate taxpayers, the personal savings allowance permits tax free interest on savings of up to £1,000 per year (or £500 for higher rate taxpayers). Beyond this limit, interest from traditional savings accounts may incur tax, which can impact overall returns, particularly for higher earners.

By contrast, because an offset mortgage does not produce savings interest, it incurs no tax liability. This can make it a more efficient choice where the effective benefit of offsetting a higher rate mortgage outweighs the interest earned on a standard savings account after tax.

Conclusion: Which is Right for You?

The decision between an offset mortgage and a traditional savings account hinges on individual financial goals, tax status and mortgage terms. Offset mortgages offer substantial interest savings, which are particularly valuable for higher rate taxpayers with larger savings balances. However, traditional savings accounts remain attractive for individuals prioritising tax free growth in ISAs or those in lower tax brackets where the benefits of offsetting may be less pronounced.

For many homeowners, a balanced approach may work best: using an offset mortgage to reduce interest on debt while keeping a portion of savings accessible in high interest accounts or ISAs offering tax free interest earnings. With the right mix, it is possible to enjoy the benefits of reduced mortgage interest and the security of a growing and accessible savings fund.

Source:

Offset Mortgages | Barclays