How do you earn over 9% on your savings?

As the Bank of England raised base rate by 0.25% earlier this month many mortgage holders will be assessing the impact on their monthly outgoings, particularly if, as some market commentators predict, the Monetary Policy Committee decides on a further increase early next year.

The most obvious way to protect yourself against any future rate increases is to fix your mortgage payments for a set period of time, which will enable you to budget effectively and provide the peace of mind associated with certainty of payments. Most mortgage customers looking at fixed rates would not necessarily associate the best value with an offset mortgage, however, how much in savings do you need to gain extra benefit and reduce the amount of interest you pay to the tax man?

Karen Wint, Head of Marketing and PR at Leeds Building Society says, "I believe there is a perception that mortgage holders need to place a large amount of savings against their mortgage debt to gain any benefit from offsetting. However, with the gap between mainstream and offset rates at such a low level, customers are now getting the offsetting facility and flexibility without paying a premium. This, coupled with the availability of discount, tracker, capped and fixed rate products means that for many customers, an offset mortgage may offer the best value and save them money over the life of the mortgage."

So how does an offset mortgage save money? If we take the example of a mortgage holder who has £5,000 of savings, most people would have tax deducted at 20% from any interest earned on their savings and a higher rate tax-payer would pay 40%. Therefore, if on savings earning 5.5%, a higher rate tax-payer would only receive £165 of their £275 gross interest after paying £110 to the taxman. A basic rate tax-payer would not fare much better, receiving only £220 and donating £55 to HM Revenue and Customs.

If, instead of receiving interest on their savings, the customer offset this against a £100,000 mortgage, what would be the benefit? For this example, we will use Leeds Building Society's 3 year mortgage, which has a fixed rate of 5.49%. Offsetting the £5,000 savings against the mortgage debt would mean that the customer pays interest on the remaining £95,000, a saving of £275 (£5,000 x 5.49%). For a higher rate taxpayer, this is the equivalent of receiving a gross return of 9.15%, which is simply unachievable any other way for a risk free investment.

Furthermore, the savings balance would reduce the amount of interest paid over the term of the mortgage by £14,322 and enable the customers to pay the mortgage off 1 year and 10 months early, assuming a 25 year term.

Karen Wint continued, "Clearly, this type of mortgage offers excellent value and can enable people to be mortgage free earlier. The savings are kept separate from the mortgage account so people have full instant access to them at any time, without penalty, and have a cheque book facility. It is also possible to add to the savings account and reduce the amount of interest paid even further."

The benefits are even greater when people add to their savings. If an extra payment of £100 a month, in addition to the mortgage repayment, is added to the savings account then the mortgage will be paid off 4 years and 6 months early (assuming a 25 year term) and the total interest saving would be £34,213.

Karen Wint added, "Building up your savings on a monthly basis really makes a difference. The more you build up, the quicker you pay off your mortgage and the amount of interest saved increases. The more you save also reduces the amount you pay to the tax man and maximises the equivalent return received. It is not necessary to have a large amount of savings to benefit from the tax efficiency, flexibility and cost saving potential of an offset mortgage."