This article on using an offset mortgage comes courtesy of Planalyst from Team Monevator. Check back every Monday for more fresh perspectives on personal finance and investing from the Team.
Paying for a home versus investing is a hot topic for the FIRE masses.
However I was late to this party.
I had already plunged in with the societal expectation that everyone starting a family should buy a ‘proper’ house. So that’s what I’d done.
And with that came a mortgage.
Laying the foundations
When I bought my first home in 2008, I hadn’t heard of the FIRE movement. I’d not even considered I might not keep working until State Pension age.
But I still wanted my mortgage debt paid off as soon as humanly possible.
Like most people who go down the home ownership route, my mortgage is the biggest liability I intend to incur in my lifetime.
(I’m aware that the Student Loan is a hefty debt for many graduates these days – including me. But I have less control or choice over its enforced repayment from my salary.)
My ideal was that once the mortgage was repaid I could focus on saving what had previously been mortgage payments into retirement savings.
A few years ago me and Mr Planalyst had created a whopping great budget spreadsheet. We now used this to plan how to pay off the mortgage faster.
Everyone should planalyse as often as possible in my (Excel work)book!
Discovering the offset mortgage
We chose a classic fixed interest-rate mortgage product, rather than a variable rate mortgage.
The fixed rate ensured efficient monthly budgeting. It also protected us against interest rates increasing again. They haven’t actually done so since the financial crash – but, as with most things, we only know that now with hindsight.
Anyway, when it came to the end of our fixed term five years ago, I looked around on comparison websites, intending to remortgage to another fixed interest-rate deal.
It was at this point the offset mortgage option piqued my interest.
And I’m glad I did my research, because it has proved its worth.
Offset mortgage, you say?
I’m going to assume you’re familiar with the concept of a mortgage, be it a fixed or variable interest-rate. However you may not be as well-acquainted with the offset options out there.
An offset mortgage enables you to ‘offset’ the balance of your outstanding mortgage with a cash balance held in a linked savings account.
Your monthly interest calculation is then based on the overall debt across these two accounts, rather than just your mortgage borrowings. The monthly payment to your mortgage company will therefore be lower than if you just had a normal mortgage product. That’s so long as you hold cash in the linked account, of course.
There are also a few options at the policy anniversary when the interest and mortgage capital balance are recalculated. You can reduce the term length or reduce the monthly payment or it’s possible to keep the same monthly amount and term as with a usual mortgage, in order to pay your debt off faster. This was what we did.
Sadly, you don’t earn any interest on the linked cash account (so it suffers from inflation risk).
However you’ll pay less loan interest instead. This saving should make up for what you could otherwise have earned on your cash.
Offset mortgage mathematics
The maths in favour of an offset mortgage works because your mortgage will usually have a higher interest rate than any cash savings account you’ll see in the wild.
The rates touted by offset mortgages are as low as 1.39% right now. That’s cheap, but it’s still higher than you’ll earn on a cash savings account.
Getting a return on your cash by reducing your debt repayments rather than earning interest also means taxpayers can store higher cash amounts without the risk of HMRC wanting its piece. This makes an offset mortgage very tax-efficient.
Even taking into account the small bit of interest I’d earn if the cash were held in a deposit account elsewhere, I’m paying less interest owed on the mortgage versus capital repayments each month. This means I’m eating away at the outstanding capital debt much faster than with my previous conventional mortgages.
It’s all clearly visible on my mortgage calculation spreadsheet, with its nicely downward sloping lines:
Note that the slope gets steeper the more that is added to the offset savings. That is very satisfying.
Offset with benefits
Committing surplus cash to the mortgage was all well and good in the early days of our indebtedness. Our goal of financial independence only materialised years later, and with it the need to accumulate wealth.
Nowadays I have a family, too. So I had to balance those responsibilities and my new FIRE ambitions with my desire to repay the mortgage quickly.
I therefore mentally earmarked my offset mortgage’s linked cash account as an all-important accessible emergency buffer.
The linked cash account can also offer quick access to cash for less devastating events. Maybe you’re a stockpicking type who has been waiting for the right moment to invest in a company you’ve followed for years? A dip in a firm’s fortunes can be your opportunity when you’ve cash to hand via an offset mortgage.
In the meantime and whatever it’s earmarked for, your cash is working to reduce your debts rather than earning diddly squat in a deposit account.
Paying off your debt
Emergencies and opportunities aside, the cash in your offset account can be committed – in part or in full – to the mortgage capital at any time.
Alternatively you could just wait until the end of your existing fixed-rate term and then reassess.
On my mortgage, there is no early repayment charge on up to 99.99% of the outstanding balance. That has made a big difference. We’ve been able to pay the capital down more quickly and ended up paying less in interest over the life of the mortgage.
Of course, different lenders will have different rules on the amount that can be thrown into actually repaying the outstanding debt. You can typically repay 10% without any early repayment penalties. The financially-savvy Monevator audience should certainly read the small print before signing.
If committing all your savings is too much to bear thinking about without a cash safety net squirreled away elsewhere, you could hold the same balance in the linked cash account as you owe on the mortgage.
Like this, you would pay no interest on the debt, but you’d maintain your emergency cash. Monthly payments would be 100% capital repayment. It would almost be like having a mortgage with no mortgage.
Of course, this method means that ultimately you would start to build up a surplus amount in your savings account – earning zero interest.
But you could periodically remove the excess cash to invest elsewhere.
I didn’t have a big mortgage to begin with. For one thing I had a chunky deposit. I was also lucky with the housing slump in the recession in 2008.
As a first-time buyer I could afford to be choosy and I chose a probate property with a ‘motivated’ beneficiary. That pushed the agreed price down even further.
Doing the sums, I was shocked the monthly mortgage repayments on my new three-bedroom semi-detached were about half the rent I was paying on a tiny two-bedroom flat overlooking Basingstoke train station.
And I wouldn’t be funding a buy-to-letter’s house in Cyprus. Instead I would be my own landlord.
So I would say I’m an advocate for buying your home if you can. We moved again for work and better schools five years ago. The mortgage repayments are still lower than the equivalent rent on my now four-bedroom semi.
I’m also happy to say that – with a few more months of additional savings into the linked cash account – I’m on track to pay off my mortgage this September. That in turn means I’ll avoid paying the bank – well, building society in my case – another 12 years of interest payments, too.
Once the mortgage is paid off, its associated monthly outgoings will instead be redirected into ISAs and the investments discussed on Monevator by The Investor et al. (Fingers crossed for another long-term bull market.)
Paying off my offset mortgage will be my first major milestone on the track to financial independence and the ability to retire early in my mid-forties.
Hopefully I will feel the anticipated exhilaration of being mortgage-free a bit more than The Accumulator did!
Over time you’ll be able to see all Planalyst’s articles in her dedicated archive.