MortgagesOct 23 2014

Distinct advantages for the self-employed

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There is no doubt about it; the last few years have been some of the most challenging for prospective mortgage borrowers, notably first-time buyers and owner-occupiers.

This might be surprising when put into the context of interest-rate stability, particularly at such historically low levels. July 2007 was when the Bank of England last increased the base interest rate – to 5.75 per cent, which was paltry compared to the levels seen at the end of 1989 when rates peaked at 14.875 per cent. Yes, I did have a mortgage then too. But if you had predicted in 2007 that there would be no Bank of England rate rise for seven years or so at least, no one would have believed you.

There are some 1.6m people who have bought their first homes since the last rate rise, and who may be understandably anxious. Couple this with the fact that we have a record number of families with at least one member who has become self-employed, either by choice or necessity, and approximately 4.6m people who work for themselves in the UK, according to the Office of National Statistics. Self-employment figures are at their highest for four decades – 15 per cent of the UK’s workforce.

Offset mortgages can offer distinct advantages for both the employed and self-employed. Let us start with the latter. Newly self-employed professionals quickly discover that certain aspects of their financial lives become more complicated. Getting a mortgage, for instance, is a lot less straightforward, with fewer lenders readily able to accept the new reality of today’s earning patterns. Offset mortgages, however, are ideally suited to those who are self-employed. They are different to traditional mortgage arrangements, but these differences bring distinct advantages to those who have to put aside money to pay tax bills on a regular basis as well as those who hold savings that they would like to put to better use. For the self-employed the benefits are twofold. They can pay back the mortgage in less time using the money that has to be put aside for their tax bill.

An offset mortgage can allow the interest savings to be used in two different ways. The first is that the amount of interest paid is reduced but the monthly payments stay the same, so the borrower is effectively overpaying each month. The result is that the borrower pays the mortgage back quicker – perhaps in 23 years as opposed to 25 years (depending on the level of offsetting). The second is that the monthly payments can be calculated to pass on the interest saved by the money in the offset account, giving lower monthly payments. Not all lenders offer both options though, and most seem to offer only the first.

The offset mortgage does not discriminate between the employed and self-employed. Both are just as likely to be eligible for an offset mortgage as for a traditional mortgage. Lending criteria may not differ for an offset mortgage compared to a traditional mortgage, and certainly that is true in the case of our sister society, National Counties. The lender will still assess affordability on the whole mortgage amount rather than adjusting for any offset and assessing on that basis.

Quick recap

Offsetting is really quite a simple concept. With a traditional mortgage a borrower takes out a loan and pays a set amount each month. For a repayment mortgage that amount is based on a contribution towards paying back the loan and an amount to pay the interest on that loan. An offset mortgage works in a similar way except for the inclusion of an extra feature; a special savings account is attached to the loan arrangement. Any money placed in the savings account is automatically deducted from the amount of the loan on which interest is charged. So if someone borrowed £200,000 and held £40,000 in their savings account, interest would only be charged only on £160,000.

Each month the lender will look at the amount held in an offset savings account and deduct that amount from the outstanding mortgage loan to work out how much of the loan should be paid interest on and what the reduced monthly payment should be.

Irrespective of how much is in the offset savings account, the interest charge will also vary as the interest rate itself changes. And there is the rub. So what challenges do interest rate rises pose over the next 12 months or so?

At the time of writing, the inflation figures for the year to September came as a surprise. The fall in the annual CPI rate from 1.5 per cent in August to 1.2 per cent in September has affected rate expectations, with analysts now taking the view that the Bank of England will not increase its base rate until Q4, 2015.

This does not mean that borrowers (and possibly their advisers) can be complacent about interest rates. The next move expected is an increase in rates – it is simply the timing of that increase which has shifted. And timing is everything.

There are two particular scenarios to consider in an increasing rate environment.

(a) if the mortgage is a fixed rate one, interest that could be earned on a conventional savings account could offer a higher return than that of offsetting and;

(b) if the mortgage is with a variable rate, the mortgage and savings rates will both increase and, other things being equal, the offset benefit will stay the same. Of course, a cynic might argue that variable mortgage rates will rise ahead of savings rates, making offset a definite winner.

If a borrower holds a reasonable amount in savings accounts he or she will have noticed that the returns over the past few years have been less than sparkling. As a general principle, the interest rates for borrowing money will tend to be higher than the rate received from saving money. So if one moved savings to count against a mortgage, the reduction on the monthly payments would exceed the savings account interest accrued. So in practice, there is nearly always more to be gained by offsetting than not, regardless of any increases or reductions in interest rates.

Case Study

Jemma set up her business as a marketing consultant two years ago. However, when it comes to getting a mortgage, she has found herself restricted by the relatively short time her business has been running and the fact that her income, while reliable, is coming in on a project by project basis rather than in neat amounts every month. When the money does come in Jemma knows she will need to put aside roughly £30,000 across the year to meet her tax bill. That money can build up in her offset account and, including a transfer of a savings account balance, on average Jemma is able to offset the interest on £40,000 of her mortgage.

With a £200,000 offset mortgage at 2.25 per cent, Jemma would save £900 a year in mortgage interest on £40,000. If she took a traditional mortgage for the same value and put the £40,000 in an easy access savings account at 1.50 per cent, she would earn £480 interest a year after basic rate tax, and even less at £360 after higher rate tax. Tying the money into a higher-earning savings account for one year would earn her more interest, but she needs to pay her tax bill twice a year so this is not an option. Overall, with the offset mortgage she is £540 better off a year and Jemma has the added benefit of knowing that when she has to pay her tax bill the money she has saved is available immediately.

Keith Barber is associate director business development of Family Building Society

Key points

Offset is ideal for the self-employed as they can use the money put aside for tax bill to reduce the amount of interest they pay.

Offset helps savers, as borrowing rates are much higher than savings rates.

Offset mortgages may not be so attractive and beneficial once the Bank of England finally starts to raise the base interest rate.