How You Might Get Stung if You Pay More
Paying more than your minimum repayments is a good idea. You can get the loan paid quicker and lower the amount you pay in interest.
However, there are some things you need to consider. If you have a fixed rate home loan, you may have break costs. These limit how much you can pay off early.
What Are Break Costs?
A break cost is a fee lenders charge to customers with fixed rate home loans who want to make extra repayments. Most banks allow you to pay a set amount above what is required each year. Exceed this amount and the break cost comes into play.
The bad news is that not all banks tell you how the break costs are calculated. If you’re not careful, you could end up paying thousands of dollars in fees.
Are Break Costs Legal?
It depends on your loan type. As of July 1st, 2011, lenders are not allowed to charge break costs on variable loans.
Those with fixed loans and those who created variable loans before July 2011 may still face break costs.
In short, break costs are legal in certain circumstances. You’ll also usually face a $350 charge whenever you clear a mortgage early. This covers the fee the bank pays for removing the mortgage from the home’s title.
Why Do Banks Charge Break Costs?
It all comes down to the money lenders borrow to provide a fixed rate loan. Your lender uses a Bank Bill Swap Rate (BBSR) to borrow money from a wholesale market. This BBSR does not offer the bank the option of 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. Unfortunately, the bank will pass this cost on to you as a break cost.
Basically, you incur the break cost if you pay off the fixed rate loan early or you pay off more than your agreement allows. You may also end up shelling out if you default on the loan or switch to a different type of loan.
How is the Break Cost Calculated?
That’s the problem. Each bank uses a different formula to calculate the fee. This means you can never be sure how much you will be forced to pay.
Break costs tend to be higher for 10 to 15 year loans. This is because the length of the loan is often used to help calculate the break cost.
A customer with a five year fixed rate loan of $400,000 with a 5% interest rate decides to sell the property after three years. During the term of the loan, wholesale interest rates have reduced by 1%.
In this case, the customer will need to repay the final two years of the loan in full, incurring a break cost if interest rates have dropped.
The formula used to find this cost will differ among lenders. Here’s an example.
Break cost = loan x interest rate change x time left on the loan
Break Cost = $400,000 x 1% (0.01) x 2 years
This results in a break cost of $8,000.
Speak to your lender directly to gauge how they calculate break costs.
When Should I Pay A Break Cost?
Paying break costs may prove useful if you want to take advantage of lower interest rates.
Example: If you have one year left on a fixed home loan at 5% – and your lender is offering a lower rate of 4% – you may want to pay off the loan early and cover the break cost. It’s also a handy alternative to refinancing.
However, you should talk to a professional such as a uno home loan adviser before deciding to do this.
How Can I Avoid Break Costs?
If you have a fixed rate home loan, you can’t always avoid break costs. However, you can manage them. 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. Don’t get caught out by lenders giving other names to their break costs either. 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.