Offset Mortgages -- the Numbers

DiggingOut

Official MoneySavingExpert.com Insert: We now have an Offset Mortgage Calculator that should help with this.

Back to the original post....

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This seems to be discussed a lot recently, on this board and the debts board.

Lisyloo did a calculation a while back that showed you needed to have 48% of your mortgage amount in savings, although this was based on certain assumptions about relative rates.

Since interest rates have moved on from there, I thought I would provide a formula which anyone can use to plug in real numbers at any time and make the calculation.

To define terms:
OffsetRate -- this is the interest rate you pay on an offset mortgage.
NonoffsetRate -- the interest rate you pay on a non-offset mortgage (generally lower)
SavingsRate -- this is the rate you can get on your savings (AFTER taxes) in a savings account if you don't have an offset mortgage
X -- this is the breakeven point. !If you have more than X percentage in savings, you will be better off with an offset mortgage, less than X you are better off with a normal/flexible mortgage.

The left side of the formula is the annual percentage interest you will pay with the offset mortgage. !The right side of the formula has two terms. !The first is the interest you will pay on your non-offset mortgage, the second is the interest you will receive on your savings.

(100-X) * OffsetRate = 100 * NonoffsetRate – X * SavingsRate
simplifying:
100*OffsetRate – 100 * NonoffestRate= X * OffsetRate – X * SavingRate
solving for X:
X = 100 * (OffsetRate-NonoffsetRate) / (OffsetRate – SavingsRate)

Obviously, the greater the difference between the rate of the offset mortgage and the best mortgage you could get otherwise, the higher the percentage has to be. !The more favourable your after tax savings rate, the higher the percentage has to be.

One of the big advantages of an offset mortgage for some people is that they run very large amounts through their current account each month, and this is set off against their mortgage, even if only for just a few days. !Since current account rates are significantly lower than savings rates, to reflect this situation the formula has to be more complicated.

Two more terms:
CurAcctRate -- the interest rate you earn on your current account balance (AFTER tax) if you have a non-offset mortgage.
Y -- the average collected balance in your current account over the course of the year, as a percentage of your mortgage balance.

On to the formula:
(100-X-Y) * OffsetRate = 100 * NonoffsetRate – X * SavingsRate – Y * CurAcctRate

Solving for X:
X = (100 * (OffsetRate-NonOffsetRate) + Y * (CurAcctRate-OffsetRate)) / (OffsetRate – SavingsRate)

X is the break-even point for how much savings you need if you have an average current account balance of Y. !So you can plug in your own numbers.

Solving for Y:
Y = (100 * (OffsetRate – NonOffsetRate) + X * (SavingsRate – OffsetRate)) / (OffsetRate – CurAcctRate)

This formula is for when you know how much savings you have (X) and are trying to determine what average balance you need in your current account to benefit from an offset mortgage. !Y is the break-even point -- more than Y, and you would benefit from the offset mortgage.

Caveat:
This obviously does not reflect differences in fees, the necessity to keep remortgaging to maintain the lowest rates, etc. !It compares non-flexible mortgages to offsets. !A flexible mortgage may be able to accomplish the same thing as an offset at lower price, if your money is in savings rather than your current account.

This also does not reflect the intangible benefit of additional flexibility that an offset provides. ! It is simply for crunching the numbers. !It may be worth it to you, even if the numbers do not quite come down on the side of the offset, to pay slightly more for the extra flexibility.

This also does not take into account at all where the money in savings comes from. !If you are a credit card tart and have significant funds from that source, it does not necessarily follow that they should be used on an offset or that they should be used on savings. !It is simply a matter of crunching the numbers to determine the best approach.

Have fun!

edit: corrected spelling error
edit (9/7/04) clarified a couple of terms to prevent confusion.

payless

And I thought I was a number cruncher ;D

DiggingOut

There you go being polite again. I know what you really mean -- that anyone who would do that posting must be out of their mind! ;D

[Deleted User]

Thankfully I no longer have an offset mortgage.

DiggingOut

Thankfully I no longer have an offset mortgage.

Does that mean you actually plugged in the numbers to find out if you are better off? Nice to have you in the ranks of the numerically insane! ;D

nitrocat

Diggingout, excellent stuff thanks.

Using your calculation I notice that the difference in interest rates between offset and non-offset can make a HUGE difference to the money saving viability of offset mortgages – for the worse.
Especially as interest rates appear to be rising, the difference could increase as well.

I guess it also effectively ties up your savings for a long time (25 years) as if you spend it you may have a very expensive mortgage.

DiggingOut

Using your calculation I notice that the difference in interest rates between offset and non-offset can make a HUGE difference to the money saving viability of offset mortgages – for the worse.

Yes. Makes sense, of course, because those are the rates that apply to the largest amount of money, typically -- so losing money through a rate differential here is particularly painful.

Especially as interest rates appear to be rising, the difference could increase as well.

I'm not sure this necessarily follows. Presumably rates will rise for both types of mortgages. The difference could decrease, in fact. I believe the difference has decreased over the last couple of years. I think lenders may want to make these more competitive, because if you do this, in effect they get your savings, current account, and mortgage all in one.

I guess it also effectively ties up your savings for a long time (25 years) as if you spend it you may have a very expensive mortgage.

I wouldn't view it that way. Just like any other mortgage, you can move to a different one if you need to reduce your savings.

The gap between mortgage rates & savings rates is not that wide right now, which makes these less attractive for savers, although higher rate taxpayers have a larger gap because you have to calculate based on after-tax savings returns.

But IMO, the real benefit of an offset is for those who are running lots of money through their current account, because for those people the current account return is so low.

For instance, someone who isn't in PAYE and only pays taxes twice a year may build up quite a balance by June and December. Other people may have very large amounts moving in and out of their account regularly. Even if those amounts are only present for a few days, they can result in significant interest savings on an offset mortgage.

payless

As I have mentioned on other threads

believe whilst offsetting does have its place- its of limited benefit to most with the current differences in offset account rates & variable trackers/discounts

Its heavily marketed - possibly as a way of lenders getting buisness in on products with higher profit margins. ( also in equity release)

Also broker commissions on offset accounts are often higher than on other types.

Some lenders are now ( at a fee) bringing in offset on their normal range.

Cautious_Ben

It is an interesting debate, but I agree with digging out that there are more variables than just pure number crunching. Offset mortgages don't have tie-in penalties, make managing both debt and savings 'simpler' for alot of folk. The rate is usually very competetive against standard variable rates, which a majority of people end up sticking with once their discount has ended. It will be interesting to see what the average rates of offset mortgages rise to once the 'big' lenders have their quotas signed up. Switching from an offset has the added complication of maybe having to change your current account as well, which will be a big incentive to just stay'n'pay.

System

What happended to all the offset mortgages that also had a hefty discount as well?
We are coming to the end of a 2yr 1.9% discount period of a offset/current account mortgage with mortgage trust ltd (formerly britannic money) that currently charges 4.29%.
There doesn't seem to be any comparable deals around which is a shame as it is very convenient having an offset but not if the rate is high!

lisyloo

I don't believe there are any good discount offset mortgages.

I haven't been following the market for long enough but I think that offsets have become less competitve with normal discount mortgages.