Offset mortgages offer a whole host of advantages to home owners. Unfortunately, many people are unaware of exactly how an offset mortgage works, if they are aware of the option at all. Whilst offset mortgages can be a touch complex, the basic principle is very simple.
Reducing Debt with Offset Mortgage
In essence, getting an offset mortgage is like combining your mortgage and your savings account together. This allows you to use your savings as a means to reducing the size of your debt.
How? The size of your mortgage is offset (hence the name) by the size of your savings. So, to give an example, if your mortgage has $300,000 left outstanding, and you have $30,000 dollars in you savings account, the debt is thought of as only $270,000, as the first $30,000 is offset by your savings.
This means, as the debt is offset, you only pay interest on $270,000, rather than the full $300,000 amount. So say if you were paying 3% interest a year, you’d pay $8,100 in accumulated interest, rather than $9,000. That’s a healthy saving of $900 for that year, but of course the numbers involved in any given real life situation may well be considerably bigger, meaning the savings will also be bigger.
(Bear in mind the example only gives the saving for a single year. You might have your mortgage for the best part of twenty years, so these savings will add up!)
It should be noted that, if you do choose to go for an offset mortgage, your savings account cannot earn interest for you (this would be having your cake and eating it!) So, the key question to ask is whether or not it’s worth sacrificing the interest you could potentially earn from your savings account in order to reduce the amount of interest you’ll have to pay on your mortgage?
Figuring this out is not simply a question of looking at which of the two interest rates is higher. This is because, whilst you have to pay the interest on your mortgage in full, you do not receive the interest earned by your savings in full. This money, as it is considered a form income, is taxed accordingly. You need to take into consideration how much of it will be going into the hands of the IRS when comparing the sum against how much you could save on your mortgage.
Tax You Need to Pay for Offset Mortgage
Even then, figuring out how much you will have to pay in tax isn’t completely straight forward as, depending on how much your other earnings amount to and how much you earn on top of that in interest, your savings may be taxed at a higher rate than the majority of your income.
This may make the reducing your mortgage, more attractive than receiving the interest you could earn from savings, especially if you would have used some or all of this income to help pay off your mortgage anyway! Another key feature of an offset mortgage is the greater level of flexibility you are afforded when it comes to paying the debt off.
There is normally no fee for early repayment. This means, if you have the funds available, you can take advantage of the reduced interest payable to clear the debt quicker, which can also lead to increased financial freedom in the future.
This flexibility is also often very useful to those who make their living through freelance work, various commissions, large infrequent bonuses, or are self employed and have an irregular income as a result. With an offset mortgage you can pay less some months and more on others, depending on your income at different times of the year.
It is not for Everyone
Of course, this does not mean that an offset mortgage will suit everyone. The rate of interest on an offset mortgage is normally higher than with other, less flexible forms of mortgage. Therefore, they will not provide much benefit to people with little or no savings.
Likewise, if your income comes in regular instalments and you outgoings remain more or less fixed each month, there won’t be much scope for you to make advantage of the option to over pay at any point.
If this is the case, you will usually be better of seeking out the mortgage with the most competitive fixed rate that you can find. These days, even fixed rate mortgages often come with some flexible features, so be sure to explore more conventional avenues before settling for an offset option.