Offset mortgages can appear complex and in some cases can seem relatively costly in comparison with more mainstream fixed or discounted schemes.
All too often, therefore, these very effective financial planning tools can be overlooked by the busy contractor who may be conditioned to look at headline-grabbing interest rates alone when deciding on which mortgage to choose.
However, the flexibility on offer and the opportunity to cut the tax you pay could be the dream ticket for any contractor.
How do offset mortgages work?
With an offset mortgage, the debt on which you pay interest can be reduced by any balance you hold on a linked credit account.
You only pay interest on the difference between the two and this enables you to lower the payments on your mortgage or overpay and reduce the term of your debt, simply by virtue of money that you hold on instant access and without having to formally pay off a lump sum from your loan.
This is particularly useful for contractors who will have a varying amount of money in their account over the course of a year but who probably won’t be happy paying off a large sum that cannot then be withdrawn in an emergency.
There is no pressure to transfer your current account to your offset mortgage provider but doing so will further enhance the benefits. This way any short term funds that you currently have gathering dust can be used to great effect.
Even the money set aside for your weekly groceries can be deemed to have been paid off your mortgage until you physically give your debit card over at the checkout and on drawing a dividend or receiving the salary from your umbrella company, mortgage interest will similarly be saved on the very same day that cleared funds appear in your current account.
With several lenders, you can link a number of these credit accounts including savings, cheque accounts, ISAs and in some cases even business accounts, which can then be used to offset against the mortgage debt to reduce the amount of interest you pay.
Offset mortgages and tax planning
Offset mortgages can also be used as a very effective tax planning tool by contractors. Instead of paying 20% or 40% income tax on savings interest in an ordinary account, you pay no tax because offset ‘returns’ are classed as avoiding interest on the debt.
If you pay higher rate tax then you could benefit from an effective rate of tax and risk-free investment return of 8% which compares very favourably with a pension or ISA.
Competitive for the long term
As these mortgages often track the base rate for life and without a limited time-frame they are likely to remain competitive for the duration of the loan and you can avoid the hassle of re-mortgaging when an initially low rate expires. In the unlikely event that you decide to change from an offset back to a more traditional mortgage, this can usually be done free from the redemption penalties that are common to other fixed or discounted rate mortgages.
Rather than sticking to a rigid schedule of set monthly payments, offset mortgages also offer you the flexibility to overpay or underpay to mirror your budget. So If you had been working a lot of extra hours then you could pay more off of your mortgage this month and take one step closer to being debt free.
You then have the flexibility to withdraw that money again in the future if you need it, for instance, to cover expenses when you are in between contracts or to pay your tax bill in January.
If you find yourself with a lower income for whatever reason then you also have the option to underpay with an offset mortgage as part of your payment can be rolled over until you can afford to overpay again. You can even take payment holidays. These features all help take the pressure off you in an uncertain contract market whilst also giving you the freedom to relax for a few months if needed.
Summary
Offsetting is all about placing your mortgage at the very heart of your financial planning and enables you to get every hard-earned penny working as effectively as possible.
The flexibility of this type of mortgage makes it ideal for freelancers and experience has shown that, even with modest credit balances, a substantial dent can be made in the 25-year term of a typical mortgage.
