How your savings can cut your mortgage and tax bills at the same time

Borrowers with as little as £25,400 in savings could slash thousands of pounds off their mortgage payments via a little-used loan.

An estimated 2.5 million homeowners will reach the end of fixed-rate mortgage deals this year and next, many of whom will see their rate double when they come to renew.

The average two-year fixed mortgage is now 5.98pc, according to financial data provider Moneyfacts – a huge increase from the average rate of 2.59pc in June 2021. Meanwhile the rate on a typical five-year fixed deal is 5.58pc.

High interest rates mean many now face paying hundreds of pounds extra a month on their mortgage, however there is a way to dodge the rise in costs.

Offset mortgages let homeowners bring down their monthly payments using cash held in their savings account.

These deals have been off homeowners’ radars for years. But with expensive borrowing costs, and savings deals on the rise, offset mortgages could present a compelling opportunity for many homeowners, provided you have enough in savings.

What is an offset mortgage?

An offset mortgage lets you offset your savings balance against your outstanding mortgage debt.

You forfeit the interest earned on your savings in order to reduce the amount of interest you pay on your mortgage.

Most offset accounts let you choose to have smaller monthly payments or a shorter overall term.

Chris Sykes of broker Private Finance said offset mortgages hold “clear advantages” but have been out of favour for years because of low interest rates.

He said: “Introduced to the UK market in 2000, offset mortgages grew quickly in popularity in the beginning, however they have languished for many years after despite offering obvious advantages.

“Amongst more sophisticated borrowers they should, logically, be much more popular, but suffer from a fatal marketing flaw: they sound complicated. Most lenders offering offset mortgages will do so at a higher interest rate which can also dissuade people.”

Offset mortgages often have slightly higher rates than standard mortgages. For example, Barclays’ five-year offset mortgage has a 6.5pc rate, compared to the current average of 5.58pc.

What’s more, only a small number of lenders offer them.

However, Mr Sykes said the potential interest savings from offsetting your savings can often outweigh the higher interest rate, making it a cost-effective option for many borrowers.

How much do I need to have in savings?

Offset mortgages are only suitable for those with a decent amount in savings.

A typical borrower with the average mortgage debt of £127,000 would need at least £25,400 in savings for an offset mortgage to be worthwhile, according to calculations by investment company Bestinvest.

Alice Haine, of the firm, said: “The general rule of thumb is that people need at least 20pc to 25pc of the mortgage amount to remain in savings to make an offset mortgage worthwhile.”  

For someone taking out a new mortgage of £184,000, they would need at least £36,800 in savings.

If a lender requires 25pc of the mortgage debt to be kept in savings, then the figures would rise to £31,750 for a £127,000 mortgage and £46,000 for a mortgage of £184,000.

How much could you knock off your mortgage?

Based on an interest rate of 6.22pc, a borrower who secures an offset mortgage at 5.77pc with a £225,000 mortgage and £100,000 in savings would be able to bring down their monthly payments from £1,480 to £960 – slashing their bills by £520 a month. 

Because they are not earning interest on their savings, they would also save £13,490 in tax, if they were a higher rate taxpayer. Basic-rate taxpayers can earn just £1,000 in savings interest before tax. The savings tax allowance for higher-rate payers is just £500, falling to zero for those paying the highest rate of tax.

You could also use your savings to reduce your mortgage term. The same borrower with a 25-year mortgage would be able to pay off their debt within fifteen years.

What are the advantages?

Offset mortgages can be especially tax-efficient for higher rate taxpayers.

Higher savings rates mean more taxpayers are paying tax on the interest earned in their savings account. Although the average rate on an easy-access savings rate still lags well behind mortgage rates at 3.17pc, the top accounts are now paying just over 5pc.

While basic-rate taxpayers can earn up to £1,000 before having to pay tax on their savings, higher-rate taxpayers get just £500 – while taxpayers in the 45p tax band get no allowance at all.

Another advantage is the account will remain separate from your mortgage account, so you still have access to your savings if you need them. You can also add to the savings pot each month, meaning the more you save the smaller your monthly repayments or shorter your repayment term will be.

What are the disadvantages?

The interest rate on an offset mortgage is typically higher than the rate on a traditional mortgage and you will need to have at least 20pc of the mortgage debt in savings, so these deals are not appropriate for everyone.

Not all lenders offer offset mortgages, so finding one can be a challenge. The lender will usually require you to keep both your mortgage and savings account with them.

Although you can still access your savings, anything you withdraw will of course affect your ability to pay off the mortgage interest.

This article was first published on July 6 2023 and has since been updated.