Why pooling can pay off

The best protection against a rise in interest rates is not to borrow; the next best is to borrow as little as possible, or borrow without paying interest. And when it comes to mortgages, most of us pay more interest than we need to.

The best protection against a rise in interest rates is not to borrow; the next best is to borrow as little as possible, or borrow without paying interest. And when it comes to mortgages, most of us pay more interest than we need to.

This is the premise behind so-called "offset" mortgages. Most homeowners have debt, in the form of the mortgage, which attracts interest payments; they also have savings that earn interest. This interest is generally lower than the interest charged on borrowings, and interest earned is also subject to tax.

An offset mortgage works by "pooling" debt and savings, with the homeowner only paying interest on the balance; if they are lucky to have more in savings than they owe on the mortgage, they will earn interest.

Clydesdale Bank, which entered the offset mortgage market in January of this year, estimates that someone with a mortgage of £117,424, the average in Scotland, and £5,000 in savings and £1,000 in their current account would save £58,000 in interest, and pay off their mortgage almost six years early with an offset scheme. This comes purely from not paying interest on the £6,000 savings that the homeowner offsets.

Such figures might seem a magical way to create money from nothing. And for homebuyers who often have a reasonable amount in savings, it can be worthwhile looking at an offset loan. "If you have between five and 15 per cent of the mortgage amount in savings, it does make sense," says Simon Jones, a director at brokers Savills Private Finance.

One reason, however, that offset mortgages have not been more popular than they could be is that the offsetting facility has tended to come at the price of a higher interest rate.

The earliest offset mortgages (known as "Aussie" mortgages, for their popularity Down Under) were based around lenders' standard variable rates, or tracker rates with a substantial margin over base rates, says Jones. Borrowers could find more attractive interest rates on traditional loans.

But the margins between rates on offset and regular loans have fallen over the last few months, and there are some highly competitive deals around, at least for homebuyers who are willing to search around for the right lender. There is also a small, but growing number of fixed-rate offset mortgages on offer. Many of these are fixed for the entire term of the mortgage, making them potentially 25-year fixed-rate deals.

For a two-year fix, broker London & Country has an offset mortgage at 5.09 per cent. Norwich & Peterborough Building Society has five-year fixed rate offsets starting at 5.69 per cent, according to Moneyfacts; Northern Rock offers 5.59 per cent for the term, for buyers with a deposit of at least 15 per cent.

For the same deposit, neighbouring Newcastle Building Society will lend at 5.25 per cent for the term, although this is a savings account-only offsetting facility, rather than the Northern Rock's or Clydesdale's, which also take current account balances into the offsetting scheme.

"Fixed rates on offset mortgages are now not significantly different from many core fixed rates," says Kevin Lilley, head of national accounts at Clydesdale Bank. "A lot of customers like to have the whole range of mortgages to choose from. On offsets the choice had been restricted to discount or tracker products. But we will provide whatever the customer needs: if they want to fix their budget, they can, and have the comfort of knowing that is what they have done."

At present, only about 10 per cent of Clydesdale customers opt for an offset mortgage, but Mr Lilley expects that proportion to grow as the concept becomes better-known. But mortgage experts feel that lenders will need to work a little harder to develop offset mortgages that work for some of the borrowers who could benefit most from them.

The self-employed, for example, could gain from offset mortgages by using savings set aside as a business contingency, or savings earmarked for tax and VAT, to reduce their mortgage interest charges. Most lenders, though, do not allow for business account balances when it comes to offsetting, even if those business accounts are with the same bank.

Sole traders, in particular, may be able to overcome the problem by switching money into a personal account set up for that exact purpose; Clydesdale, for example, allows up to six accounts in its offset scheme, so these could certainly be used to offset "business" savings.