On a variable loan, paying more than your minimum repayments is a good idea; you get the loan paid down quicker and lower the amount of interest you pay. However on a fixed-rate loan, making extra payments – above the limit your lender allows – can be a costly mistake.
If you pay a fixed rate home loan off early, your mortgagee is likely to charge you break costs, which can amount to thousands of dollars. Therefore it’s important to understand that fixed rate loans come with a breakage fee, and to carefully consider your options before taking out a fixed term home loan.
What are break costs?
A break cost is a penalty fee to customers who close their fixed rate loans before maturity.
Banks charge this because they borrow from the wholesale money markets to fund the loan that they provide you, and do not have the option of paying this off early.
By closing your loan before the end of its term, you breach the contract that you set with the lender. As they need to keep servicing their loan without your scheduled payments, they incur costs that they seek compensation for.
Before entering a fixed rate loan agreement, it is worth finding out how the lender calculates break costs and what these are likely to amount to. There is always a chance you may need to exit your loan early, so it’s important be informed on this before you enter your loan agreement
Why do you pay break costs?
Your lender uses a Bank Bill Swap Rate (BBSR) to borrow money from a wholesale market to provide your loan. This BBSR does not allow early repayment.
If you start making more payments, you throw the BBSR off balance. If the BBSR falls between the time you took out the loan and the date when you paid it off, the bank incurs a cost. The lender will then pass this cost on to you as a break cost.
You will incur a break cost if you pay off the fixed rate loan early, or you pay off more than your agreement allows. (Many loan providers will allow you to make some additional payments – this is an attractive loan feature to many).
You may also face break costs if you default on the loan and it becomes payable immediately, or if you refinance your loan.
How do banks calculate the break cost?
Each bank uses a different formula to work out its break costs, so it’s worth finding out how your lender calculates this fee.
Here is a sample formula:
Break cost = loan x interest rate change x time left on the loan
To demonstrate this, imagine a customer has a five-year fixed rate loan of $400,000 paying a 5% interest rate, and decides to sell the property (and pay the loan off) after three years. During the term of the loan, wholesale interest rates reduce by 1%.
In this case, the customer will need to repay the final two years of the loan in full, incurring a break cost as interest rates have dropped. Therefore their break cost would amount to:
Break Cost = $400,000 x 1% (0.01) x 2 years
This results in a break cost of $8,000.
Generally the longer the time left on the loan, the higher the penalty fees tend to be. So it’s worth keeping this in mind when choosing a fixed rate loan term.
Are break costs legal?
Break costs are legal and payable for those who close fixed rate loans early. They may, however, be known as an early exit fee, early repayment penalty, or equivalent term with your provider.
On variable loans, as of 1 July 2011, lenders are not allowed to charge break costs. The loans that precede this date may, however, be still subject to them.
You’ll also usually face a small charge of around $350 whenever you clear a mortgage early – even if your loan is 100% variable. This covers the fee the bank pays for removing the mortgage from the home’s title.
How can I avoid paying break costs?
If you have a fixed rate home loan, you can’t always avoid break costs; life happens and you may need to refinance your loan or sell your house under unexpected circumstances, which can result in paying off your existing mortgage early.
You can, however, manage break costs and be informed. A break cost calculator can help you calculate how much you’ll pay. Some lenders will tell you what their limits are. Speak to the lender to find out more.
Also, bear in mind that banks may change their policies. Stay on top of this to make sure you don’t get bitten with a fee you weren’t expecting. Also don’t get caught out by lenders giving other names to their break costs. Any fee that has the phrase ‘early repayment’ attached to it is probably a break cost.
A good option may be avoiding fixed rate loans altogether. A variable rate home loan can offer more flexibility. Alternatively, you can take out a flexible fixed rate loan to get the best of both worlds. You may be able to switch and save.
When should I pay a break cost?
Sometimes it makes sense to pay a break cost, such as when refinancing your home loan to a lower interest rate or to a product with better features. It may make sense to carry a cost in the short term that will enable you to save more over the long term and pay off your mortgage sooner.
Speak to a uno home loan adviser to find out more.
With Alexi Neocleous
The information in this article is general in nature. Please seek advice from a licensed professional when making financial decisions.