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The term flexible mortgage refers to a residential mortgage loan that offers flexibility in the requirements to make monthly repayments. The flexible mortgage first appeared in Australia in the early 1990s (hence the US term Australian mortgage), however it did not gain popularity until the late 1990s. This technique gained popularity in the US and UK recently due to the United States housing bubble.
The term mortgage acceleration is also used, as the mortgage loan can be paid off faster than standard mortgages if the borrower is in a position to do so. With traditional mortgages, borrowers often face large penalties for additional capital repayments or if payments were not made on time.
A specific type of flexible mortgage common in Australia and the United Kingdom is an offset mortgage. The key feature of an offset mortgage is the ability to reduce the interest charged by offsetting a credit balance against the mortgage debt, with interest charged based on the outstanding net debt. Some lenders have a single account for all transactions, this is often referred to as a current account mortgage.
Typical features include the facility:
- to make overpayments / extra repayments (more than the normal amount)
- to redraw (borrow back) any previous overpayments / extra repayments
- to underpay - less than the normal amount
- to take a payment holiday - stop repayments for a period, typically 3 to 12 months.
These features allow a flexible mortgage to be adaptable to individual circumstances. This is especially useful for self-employed borrowers and those with a variable income, i.e. those whose income is not always fixed. By way of example, borrowers whose income includes a significant but irregular commission component might make use of commission payments to make overpayments, thereby reducing the term or enabling them to underpay at other times.
The key feature of an offset mortgage is the ability to reduce the interest charged by offsetting a credit balance against the mortgage debt.
For example, if the mortgage balance is $200,000 and the credit balance is $50,000, interest is only charged on the net balance of $150,000. Some lenders have a single account for all transactions, this is often referred to as a current account mortgage.
Lenders normally set a credit limit at outset of the mortgage and allow borrowers to credit and redraw up to this limit. This limit may be periodically reviewed. The lender may place restrictions on the lending limits towards the end of the mortgage term with the aim of ensuring capital repayment. However many lenders allow full drawdown up to the end date of the mortgage where the loan must be repaid. This can cause great problems for undisciplined borrowers and those approaching retirement if the lender is unwilling to extend the term (especially on the grounds of age).
Other lenders have multiple accounts. As a minimum there is a mortgage account and a deposit account. Often the lender allows multiple accounts for credit balances and sometimes for debit balances. These different accounts allow the borrowers to notionally split their money according to purpose whilst all accounts are offset each day against the mortgage debt.
Savings versus reduced interest
Offset mortgages are helpful because the interest rates on mortgages are higher than the interest rates of a savings account.
For example, if one had a home loan of $600,000 at 5% per year and an offset account where you have deposited $200,000, then you would be charged interest only on the $400,000 (i.e. $600,000 − $200,000). The new interest payable here amounts to $20,000 ($600,000 × 5% - $200,000 × 5% = $400,000 × 5%). Therefore you have basically reduced the interest by $10,000 (200,000× 5%), in comparison to the original interest that amounts to $30,000.
Without an offset account, this $200,000 would be saved in a savings account which would have an interest rate of 3.5% per year. If you had the money in your account for one year, the interest earned would amount to $7,000 ($200,000 × 3.5%).
Comparing the two options, the first one allows reducing the interest by $10,000 while the second gives $7,000. Therefore, putting money in an offset account allows saving more money by reducing interest than any interest earned in your savings account. In some countries like Australia, government bodies like the ATO will also tax people on any interest they earn from savings, so this will actually reduce your savings furthermore.
Offset mortgages may have tax advantages for the borrower, since instead of earning interest on the credit balance (which may incur tax), the credit earns a reduction in the mortgage interest paid (which does not). For example, in the UK offset mortgages are often marketed as offering "tax efficient" savings. Interest generated within deposit accounts for UK residents is deemed income and is taxed at source; the rate is at least 20%. This is on top of the fact that banks usually charge a higher rate of interest on loans than they pay on savings, adding a further benefit.
- Confused.com, Are Offset Mortgages worthwhile?
- direct.gov.uk, Tax on bank and building society accounts