The Value of Offset Mortgages in the Wake of the COVID-19 Pandemic Francois Moreau

The Value of Offset Mortgages in the Wake of the

COVID-19 Pandemic by Francois Moreau, Writer and Risk Analyst

The housing market in the United States has been scorching for the last year, with prices skyrocketing and supply plummeting. Homes sell within days, if not hours, of going on the market. Competition for existing homes is stiff, with many properties receiving numerous offers, often in cash and frequently well over the asking price. Some buyers have even paid 7 figure premiums over the asking price to beat out other potential buyers.

Most buyers can’t afford to pay cash for their new home. But the prospect of a mortgage well above what the buyer initially intended to pay is daunting. Not only may there be difficulties obtaining the mortgage because the assessed property value can’t keep up with the bidding war, but if buyers successfully get the mortgage, the payments may be quite high.

One mortgage option gaining popularity globally in recent years is the all-in-one or offset mortgage, which allows buyers to reduce interest payments by applying their savings against their mortgage balance. Indeed some banks have seen the requests for offset mortgages double in the first quarter of 2021 compared to 2020.

So how do offset mortgages work, and who should take advantage of them? We address these questions and more below. How does an offset mortgage work? First, it is essential to understand the terminology. The word offset refers to the fact that money contained in linked savings or checking accounts offsets the mortgage balance, reducing interest payments and allowing the buyer to pay the mortgage off more quickly.

However, if you are looking for offset loans in the United States, you may not find them under this name. Because of IRS regulations prohibiting using earned interest to offset paid mortgage interest, the term offset is not completely appropriate. Buyers will often see them referred to as all-in-one loans instead. The IRS regulations also make US offset loans operate slightly differently than in other countries.

So how does an all-in-one mortgage loan work in the US? When a homebuyer applies for an offset loan, they get several different accounts: the mortgage loan, a checking account, and a line-of-credit or loan against the equity in the home. All of these accounts must be at the same institution.

Money sitting in the checking account reduces the mortgage principal balance when calculating interest. Because interest payments are consequently lower, the monthly mortgage payment reduces the outstanding principal balance more quickly, allowing homeowners to pay off their mortgage much faster.

Homeowners can still use the money in the checking account as they would in any other checking account. Withdrawals from the checking account take the form of increases in the home equity line outstanding balance.

Why does this help homeowners? Consider the monthly cash flow of a typical homeowner who has a direct deposit for their paychecks. Most people will not spend all of their salaries as soon as it comes in the door. So the money is there to help

reduce the mortgage balance until the homeowner spends it. Because the bank calculates mortgage interest daily, the days following the deposit of the paycheck have a much lower accrued daily interest.

Let’s look at a specific example in the context of the new gig economy. Because of COVID, the prospective homeowner, Avery, is a freelancer, a popular career path following the massive unemployment resulting from the pandemic. Indeed, according to recent surveys, three-quarters of fulltime freelancers in the United States are making just as much income as they were when employed before the pandemic struck.

Avery makes $7500 a month. They want to buy a $300,000 home and let’s say the going rate is 3%. After putting 20% down, the monthly payment for a 30-year mortgage (not including set-asides for property taxes and ignoring closing costs or other fees) is $1,011.85. After deducting taxes and other living expenses, Avery saves 10% of their income or $750 a month in their associated checking account.

Avery gets several benefits from an all-in-one mortgage. First, because Avery’s expenses are spread through the month, their paycheck balance helps reduce daily accumulated interest. And because Avery doesn’t spend all their paycheck, the mortgage’s principal balance rapidly declines, further reducing the accumulated interest. Avery keeps their accrued savings but may reduce the payoff time for their mortgage by half.

In other countries such as the United Kingdom, Australia, and New Zealand, offset loans are much simpler. The amount in savings directly reduces the principal balance used to calculate interest, but there is no associated line of credit as in the US.

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Why are offset loans so popular right now? The answer is relatively simple. COVID created a savings boom, but interest rates on savings accounts have been historically low since the subprime mortgage crisis caused the housing market to collapse in 2008. So there are a lot of people with increased savings looking for a better return.

The rapid increase in remote working arrangements and the number of freelancers also contribute to the interest in offset mortgages. As more and more people work from home, they are looking for homes with amenities more suited to their new work paradigm. Whether refinancing to improve an existing home or finding new properties, remote workers are looking to apply the savings they built during the pandemic efficiently, and offset mortgages give them that opportunity. While both savings and lending should respond similarly, there may come a time when it once again makes more sense to invest money in traditional savings vehicles. And buyers must also watch closely for any signs of a new housing bubble. If a new bubble bursts, holders of offset mortgages could find themselves with negative equity and high-interest rates, a recipe for disaster.

Francois Moreau is a fintech writer and financial risk analyst based out of Paris. For the last decade, he’s worked building financial risk models for multinationals and local banks.

Who should consider an offset mortgage? Offset mortgages are not for everyone and, indeed, not everyone is even eligible to apply for one. Homebuyers must have excellent credit to qualify for an offset mortgage, as most lenders require a FICO score above 700 for applicants.

Homeowners also should only consider offset mortgages if they are confident that they can consistently save money, i.e., have a consistent positive cash flow. Because the interest rate on offset loans is typically higher than for conventional mortgages, reducing principal through disciplined savings is necessary to make an offset mortgage work.

One group that potentially stands to benefit substantially from offset mortgages is the millennial generation. Although they do have significant debt issues, they are also firm believers in saving money. Indeed, millennials start saving much earlier than their parents and grandparents (average age of 24) and are more likely to put money in savings rather than in investments. So, an offset loan can give Millenials the best of all worlds - they can save as they normally would, while also more quickly reducing their debt load and creating equity in a home, which is itself an investment.

What’s the future for offset mortgages? While offset mortgages are currently promising for savers, prospective homebuyers should keep an eye on the market because the government has recently indicated an intent to begin increasing interest rates.