One of the biggest decisions when considering your mortgage is whether to choose a fixed rate or variable rate home loan, or a combination of the two. With fixed rate home loans currently the lowest on the market they’re a popular choice for new mortgagees but breaking your loan down the track can be an expensive process.
What is a fixed rate home loan?
A fixed rate home loan is a mortgage that locks in an agreed interest rate for a certain amount of time and is different to a variable rate home loan where the percentage of interest you pay fluctuates with the market. This is a legal contract guaranteeing that you’ll repay a fixed amount of interest on a loan for a specified time period.
Variable interest rates are often more popular with borrowers when interest rates are high to avoid locking in a high interest rate for a long period of time and in the hopes that they’ll be able to take advantage of a lower rate if the market shifts.
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Fixed rate home loans tend to be more appealing when interest rates are low. Thanks to historically low cash rates fixed rate home loans are proving one of the best options available right now. A fixed rate home loan also makes it easier to keep to a budget and offers peace of mind knowing your repayments will be the same month-to-month, as well as offering some insurance against rising interest rates. However, a fixed rate home loan locks you into your mortgage, meaning if you plan on selling you’ll have to pay fees and other costs to break your contract.
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What does it mean if you break a fixed rate home loan?
A fixed rate home loan gives you peace of mind that your repayments will remain consistent, but if also gives your lender peace of mind that they’ll receive repayments for the given length of time.
If you choose to end your contract by selling your property, switching loans or lenders or refinancing, your lender will require you to compensate them for lost interest.
A fixed rate home loan is considered broken with the borrower switches to a different product, makes extra loan repayments outside of contract stipulations, repays the loan in full before the end of the fixed rate period, or when the loan is in default.
When lenders agree to lend you money at a fixed interest rate, we obtain money from the money market at wholesale interest rates based on you making your payments as agreed until the end of the fixed rate period. If you don’t, and wholesale interest rates change, we can make a loss.
What fees do you have to pay if you break a fixed rate home loan?
The most common fees associated with breaking a fixed rate home loan are break costs and exit fees.
You may also be required to pay a discharge fee to cover administrative costs, typically around $300-$400, which also covers the cost of the lender removing the mortgage that was registered on the title of your property.
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When do break costs apply?
A break cost will apply:
- If at any time before the end of a fixed rate period you choose to or are required to prepay all or part of the loan, then you must pay the lender the prepayment break costs that they calculate. However, you could be able to make additional prepayments up to your prepayment threshold over the total fixed rate period without incurring a break cost.
- If at any time before the end of a fixed rate period you switch to another product, interest rate (fixed or variable) or repayment type, then you must pay the lender the switching break costs that they calculate.
Each of these events is considered a “break”.
When there is a break, you will also need to pay an administration fee regardless of whether a break cost is payable.
Most lenders will allow for some early repayments each year for fixed rate home loans without being charged additional fees.
Each lender will have their own set of terms and conditions that will detail when break costs will apply and how they’re calculated.
However, break costs are more likely to be applied when the current cash rate is lower than the rate when you took on your mortgage, and the lender is set to lose money when they establish a new loan.
If current interest rates are higher than your fixed rate, they might be more willing to let you out of your mortgage contract without charging costly break fees as they benefit from your exit.
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Why do lenders charge break costs?
When you agree to your mortgage contract your lender borrows money from the wholesale money market using the current Bank Bill Swap Rate (BBSR), which is locked in at the same time as the interest rate of your fixed rate home loan.
The lender agrees to pay this debt back but does not have an option to repay a loan early so when you break your loan they will need to lend the money back out to another mortgagee. If this new loan is taken out at a lower interest rate than your initial loan the lender loses money on the loan you broke.
While break costs can seem like an unfair fee, this is a way for the lending institution to recoup some of their lost funds.
How are break costs calculated?
While breaking your fixed rate home loan might not always incur large break costs, if the interest rate is not in your favour this can become quite a high cost.
Your break cost is calculated by finding the difference between the cash rate at the time you took out your mortgage and the current market rate, and using this to calculate the loss to the lender if they were to lend out the fund allocated to you at the current market rate.
Generally, you will need to pay a break cost if, at the date of the prepayment or switch, current Wholesale Interest Rates are lower than your original Wholesale Interest Rate.
Wholesale Interest Rates are lender estimates of the current cash rate at which lenders can transact fixed rate funds with the money market.
Among other things, the break cost formula takes into account:
- The original Wholesale Interest Rate on the date your interest rate was fixed;
- The current Wholesale Interest Rates at the time of your prepayment or switch;
- The prepayment threshold that lenders could allow you to prepay over the fixed rate period;
- Any unpaid interest you may have;
- The timing and dollar amount of repayments required under your loan contract; and
- The remaining fixed interest rate period.
Each lender will have their own calculations that they’ll use to determine the break costs and should be able to provide you this formula as well details on their specific policies.
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What is an early repayment cost?
An early repayment means early repayment of the whole, or part, of the unpaid balance of your loan account, before the end of the Fixed Rate Term that was current at the time. An Early Repayment Cost or Early Repayment Adjustment may be charged when you repay a fixed rate loan before the end of the fixed rate term. This will occur when the cost of funds at the start of your fixed rate loan exceeds the cost of funds at the time of repayment, resulting in a loss to the lender.
Early Repayment cost amounts can change from day to day. We recommend speaking to your lender to find out what your early repayment costs could be and what options they recommend.
What are exit fees?
From 1 July 2011, the National Consumer Credit Protection Regulations 2010 (National Credit Regulations) prohibited early termination fees for residential loans, subject to some limited exceptions.
According to the Australian Securities & Investments Commission many home loans and loans for residential investment properties have early termination fees, which are payable if a customer terminates a loan within a specified time (e.g. three to five years). Early termination fees can be a barrier to consumers switching loans by ‘locking’ them into loans with unfavourable interest rates if the early termination fee is also high.
An early termination fee does not include any fee or charge that is payable regardless of whether the loan is repaid early or not (e.g. standard discharge fees and charges).
This type of fee is said by lenders to be charged to recover the economic cost to the lender of a customer terminating a fixed rate loan before the end of the fixed rate term. It is not charged for variable rate loans. *
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How long is a break cost quote valid for?
Given that break costs are calculated using the daily interest rate the applicable break cost for your mortgage changes day-to-day. However, lenders will generally provide an estimate that is valid for 2-5 business days depending on your lender. Once your quote expires you’ll need to seek a new one at the current interest rate.
Words by Danielle Austin
Is your current interest rate still competitive? Contact one of our mortgage brokers to compare your options and find a deal that suits you.