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The best offset mortgage deals

Interest rates on deposits are pitifully low at the moment. But there is one way you can still put your money to work: get an offset mortgage. Ruth Jackson picks the best deals on offer now.

Interest rates on deposits are pitifully low at the moment. But there is one way you can still put your money to work: get an offset mortgage. This product links a savings account to your mortgage loan and offsets the two. The idea is to reduce the amount of your mortgage on which you pay interest. For example, if you have a £100,000 mortgage and £20,000 in savings held separately you pay interest on £100,000 at your mortgage rate and receive taxed interest on £20,000. However, with an offset mortgage you give up the interest income so that you only pay interest on a net £80,000 loan.

The idea is catching on. Offset mortgages made up 11% of all new mortgages sold in the second quarter of this year, according to the Council of Mortgage Lenders. That's up from 8.5% in 2007. The main reason is the low interest rates available on saving. Most peoples' savings income won't even keep pace with inflation, after tax. So they are far better off using the balance to reduce the higher interest (in most cases) being paid on a home loan.

Sales of offset mortgages are also rising because they're becoming more competitive. A few years ago the best offset mortgage rates were still 0.75%-1% higher than the leading traditional mortgage products, says Damian Clarkson on MSN Money. Now that gap has shrunk average offset mortgage rates are only 0.1% higher.

But before you rush to set one up, watch out for the compensation rules in the event your lender goes bust. Under the existing terms of the Financial Services Compensation Scheme (FSCS), borrowers with an offset mortgage would see their entire savings used to cancel out part of their debt. So if you have a £200,000 mortgage and £100,000 in your offset savings account, that £100,000 would be applied to pay down your loan (rather than being paid back), leaving you with a £100,000 mortgage.

But there's some good news: from 31 December only savings above the new £85,000 Europe-wide compensation limit will be netted off in this way. If you take the same example, £85,000 of your savings would be safe, but £15,000 will be taken off your mortgage. If your lender went bust, you'd be left with £85,000 in savings and a £185,000 mortgage. Each individual gets £85,000 of savings protected. Thus if you have a joint offset mortgage, only savings above £170,000 would be netted off. The best deals are at MoneySupermarket.com. FirstDirect offers a two-year offset deal at 1.89% above the Bank of England rate with a £99 fee. You'll need a 35% deposit first.

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