Like many people, you might be borrowing money and paying interest on your mortgage, but at the same time, saving money and earning interest on your savings.

It might seem entirely logical and practical, therefore, to combine the interest paid with interest earned into a single account – not only as a matter of convenience but also to ensure that your money is working its hardest for you.

This is precisely the principle of an offset mortgage. So, how does an offset mortgage work?

How an offset mortgage works

An offset mortgage may be set up if you are borrowing and saving with the same mortgage provider.

In place of a standard savings account, your lender sets up a special account, linked to your mortgage, into which you also deposit your savings. In that offset account, the amount of your savings is offset against your outstanding mortgage balance. That means that you are only paying mortgage interest on the balance remaining once the value of your savings has been deducted from your outstanding mortgage – potentially, creating a significant impact on the outstanding mortgage balance.

Your savings are not used to actually pay off any of the mortgage balance, but the two balances simply sit side by side, with your savings helping to reduce the mortgage interest you pay.

Potentially, an offset mortgage might prove an ideal way to save money. The economic case is made by comparing what a standard mortgage might be costing you, how much you are currently earning on your savings and, what the comparable figures might be if you set up an offset mortgage account with your lender.

To help you make that comparison and calculation, the Money Saving Expert has published a ready-reckoner to give you a broad indication of the likely effects of setting up an offset mortgage.

An example

An example might help to illustrate just how this might work.

Say you have an outstanding mortgage balance of £100,000 and savings of £10,000 which you combine into a single offset mortgage account. Because the £10,000 in savings is used to offset the mortgage balance, you only pay interest on the net balance – £90,000. In a year, therefore, with interest at, say 3%, you stand to make a saving of some £300.

A regular savings account is likely to pay somewhat less in interest (if it were 2%, say, you would earn £200 in interest on your £10,000 savings). Importantly, though, and unlike an offset mortgage, you may also have to pay income tax on income earned by way of interest on your savings.

Cheaper monthly instalments or a shorter mortgage

An offset mortgage is typically used to reduce the cost of the monthly mortgage repayments you pay – thanks to the savings on interest charged on the reduced balance of your outstanding mortgage.

Alternatively, however, those savings might be used to shorten the term of your mortgage. You continue to pay the full amount of interest on your mortgage balance. Still, the offsetting element of your savings reduces the effective term of your mortgage – and you become mortgage-free at an earlier stage in your life, explains Money Facts.

The pros and cons

Probably the chief attraction of an offset mortgage is that you are likely to save more on mortgage interest payments than your savings would earn in a regular savings account. Bear in mind, though, that your savings are not earning any interest while they are in your offset mortgage account.

For as long as they remain in your offset mortgage account, your savings won’t be growing in value – with the disadvantage of their losing their effective value or buying power over time.

You have ready, instant access to your savings and may withdraw funds at any time – though mortgage repayments are likely to go up as you withdraw the savings.

You pay no income tax on the savings you are making – unlike the tax you have to pay on any interest earned in a regular savings account.

It is your choice whether your savings are used to offset the amount you repay in monthly mortgage instalments or whether you continue to pay the same mortgage repayments but shorten the term of the mortgage.

By carefully balancing the pros and cons of an offset mortgage – and by using one of the several online calculators available and the services of a specialist offset mortgage broker – you may decide whether an offset mortgage represents an attractive opportunity for you to save.