What is an offset mortgage and how does it work?

In simple terms an offset mortgage is a mortgage that allows the borrower to offset their savings against their mortgage debt in order to reduce interest payments. An offset mortgage could be ideal for those with a reasonable level of savings, or need to put money by for tax payments for example.

There is usually a savings or current account tied to the mortgage account. The money placed in the tied account is offset against the money owed on the mortgage. So, for example if the outstanding mortgage loan is say £150,000 and £15,000 is in the savings or current account the interest payments would be calculated on the balance which is £135,000. Therefore this helps reduce the monthly mortgage payments. If the amount in the offset account goes up or down it will change the amount of interest due that month, as interest is calculated daily. This means if income is placed in the account and drawn out over the month the interest benefit dwindles over the month.

There are 2 choices as a borrower, and that is to either keep payments based on the full mortgage loan which will mean making overpayments each month and reduce the overall term and pay less interest; or keep to the full term and pay reduced monthly payments based on the amount offset.

An offset mortgage can be extremely tax efficient because the borrower is not paying tax on any interest earned if the money was in a standard savings account. The borrower is leveraging the full interest rate of the mortgage without any tax implications because it is the debt being paid off rather than interest earned when using the funds in this way.

So for those higher-rate tax payers it is a very efficient way of reducing tax payable on interest earned. For self employed borrowers it can be an effective way of building up money owed to Inland Revenue and at the same time reducing the monthly mortgage interest payments.

This sounds pretty good, but as always it is best to seek professional advice. Many mortgage deals these days have the facility to make overpayments and allow withdrawals - either a proportion of the loan per year or unlimited. As the interest rate for offset mortgages may be a little higher it is vital to investigate whether an offset mortgage or a more traditional type mortgage with an overpayment facility is the best option for the given circumstances.