Is the compensated mortgage benefit still valid? -Monevator

GWhen I came forward, I was often told that paying off your mortgage was the best financial decision you could make.

Admittedly, a funny read for an eight year old. But the thought stuck in my mind.

Paying off debt makes for sexy headlines. Santander noted earlier this year that participating in Dry January – and instead spending all your drink money on overpaying your mortgage – could wipe £28,373 off your mortgage payments over 25 years.

I’m thinking of taking up drinking at Christmas so I can give it up again next year!

When you read Monevator However, you will know that it is often a smarter decision to invest instead.

But what if you already invest as much as you want, and you notice that you still have a few thousand euros lying around?

Of course you can pay too much on your mortgage. But you often face fines if you overpay the first 10% of your mortgage value.

And what if you suddenly want that money back? Well, then your bank will usually have closed its fists tightly around your money.

Offset mortgages: the best of both worlds

Offset mortgages are a great solution. Monevator has discussed them in detail before.

In summary: with an offset mortgage you put your money in a designated account with your mortgage provider. It then subtracts that cash balance from your total debt balance each month before calculating your interest.

For example, if you have a mortgage of €250,000 and €40,000 in savings, you will only pay interest on the remaining debt of €210,000.

On paper it’s a fantastic idea. You don’t have to pay tax on the savings interest, you can actually make unlimited overpayments and you can withdraw your money when you need it.

Here’s the catch

With my mortgage coming up for renewal soon – and after hearing from so many offset mortgage fans over the years – I’ve been looking into whether our next mortgage should be an offset.

That’s easier said than done, because today the offset mortgage resides in a dark and dusty corner of the financial services industry – a relic of years ago.

Maybe because rates were so low for so many years, people forgot about them?

Whatever the cause, I was disappointed to discover that many lenders these days don’t offer compensation, or otherwise limit it existing borrowers. As a future lender, it can therefore be difficult to find a suitable lender.

Barclays offers (as of December 16) just two mortgage options for home purchases, compared to 28 products without offset functionality.

Yorkshire Building Society (YBS) (from December 17) is similarly offering two – out of a total mortgage range of 11.

So even for the few lenders that offer them, offsets are a niche product.

Mortgage math

Anyway, let’s compare some of the options available (as of December) for customers with a 75% loan to value (LTV):

At Barclays you pay a 1.01% higher rate for the luxury of compensation. And an additional € 1,749 is added – no less than € 750 higher than the standard tracker.

Why should it cost more? Who knows? Perhaps the bank should share data between the savings and mortgage team via specially trained carrier pigeons.

Yorkshire Building Society is doing slightly better. It only wants an extra 0.4% on the mortgage interest.

Higher rates and fees can negate the benefits of offset mortgages

Now we’ll put some real numbers on these scenarios.

Suppose Peter wants to borrow £400,000 over 30 years.

It’s worth keeping in mind that just because Peter likes the look of YBS products doesn’t mean he’s willing to lend money against his property.

So we imagine a scenario where he can only get a mortgage from YBS, and a scenario where he can only get a mortgage from Barclays:

At Barclays, Peter would cost himself a whopping £9,396 extra for the luxury of a mortgage.

With YBS he incurs an additional cost of £3,161.

Show me the money

Okay, that’s the bad news out of the way. Time to free up Peter’s savings and get those compensatory benefits, right?

We assume that Peter is a 40% taxpayer (compensations would look a little better if he was a 45% taxpayer and a lot worse if he only paid 20%), that he has already used his £500 tax-free savings allowanceand that he has no more ISA space left.

The compensatory benefits with an offset mortgage obviously depend on how much Peter actually has in savings.

So let’s look at four possible scenarios. (All figures are annual):

Ouch!

Okay, considering the savings income alone – achieved because the interest reduction from using a savings account is not taxable for income tax purposes – Peter is indeed significantly better off with a savings account, compared to keeping the money in a taxable savings account.

But the higher rates and fees that also come with the offsets quickly erase the gains.

Because the Barclays mortgage costs an extra £9,396 in interest and fees, even if Peter had £200,000 to offset, he would still be better off with a standard tracker with his money in a savings account.

I have no doubt that many people have plenty of cash. But it must be a vanishingly small portion that wants to have savings worth half their mortgage value.

With YBS it only starts to make sense when £200,000 in cash is allocated against the compensation. But Peter still only benefits €239 after all the extra costs of the offset option.

As for me, I wouldn’t take out a £200,000 mortgage for such a vile porridge.

Also keep in mind that in either of these scenarios, Peter could probably have simply borrowed less and put the extra money in his deposit.

What is your goal with an offset?

It’s easy to fall into the trap of making decisions because they feel good, rather than because they make financial sense.

When people talk about how compensating mortgages have allowed them to get out of debt faster by saving thousands in interest payments… well, it all sounds very enticing.

Maybe that was your experience. But given current interest rates, a creditor is likely worse off than if he had the usual option of putting his money in a savings account, or simply maximizing the overpayment on a standard mortgage.

It’s true that there are a few scenarios where offsets can still make sense.

Perhaps you want to hold large amounts of cash while you wait for the right buying and leasing opportunity to arise? Or maybe you get big bonuses every now and then, but you have to keep large amounts of cash on hand for school fees? Or to have the yacht maintained?

The frustration for me is that offsets can be a very valuable product, especially with… tax on savings the Chancellor’s latest target.

The government plans to increase tax on savings income to 2% above respective income tax brackets between 2027 and 2028. Who knows if there will be further increases.

So offset mortgages appear attractive to higher tax rate taxpayers who have cash to spare.

There’s also a lot to be said for having the flexibility to simply put extra money into compensation when you have it and take it out when you need it.

But as of today, their uncompetitive interest rates and fees make them unattractive to most.

Your mortgage mileage may vary

As is probably clear by now, I love the concept of offset mortgages.

But unfortunately the numbers don’t work for me.

Even if I had 50% of my mortgage balance available in cash, I still wouldn’t take out a product that only makes financial sense if I kept that cash balance for the entire duration of a two-year mortgage term.

If you really need to have a lot of cash on hand – just in case, for some reason – then compensation may be worth considering.

Better rates may also be available by the time you take out a new mortgage.

But at this point I don’t see a reason for most people to pay more to compensate.

Likewise, if you already have an offset mortgage, run the numbers to see if you’re actually benefiting as much as you think. You may be better off overall with a standard – cheaper – mortgage product and your money in a competitive high-interest savings account.

Even if it means sacrificing your beloved offset!