What happens if I break a fixed rate home loan contract?
A guide to the costs and fees associated with breaking a fixed rate home loan contract.
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A fixed rate home loan is a legal contract guaranteeing that you'll repay a fixed amount of interest on a loan for a specified time period.
If you decide to break that contract by switching loans or lenders, your existing lender must be compensated for any loss they incur. Breaking a home loan during a fixed interest period can be expensive, which is why it's always worth getting a quote from your lender before breaking a fixed interest rate home loan.
It's worth thinking sensibly about the flexibility you'll need in the future with your home loan before locking in a fixed interest rate to avoid having to pay break costs. If you're concerned about flexibility then you might want to consider a variable mortgage instead.
What is considered "breaking" a fixed home loan?
- Switching to a different product
- Extra home loan repayments in excess of an accepted tolerance
- Repaying the loan in full before the end of the fixed rate period
- When a loan is in default, requiring it to be repaid immediately
What fees do I have to pay?
There are two fees to pay when you break a fixed home loan:
- Early repayment adjustment/Break fee/Early exit fee (the expensive one)
- A discharge fee/early repayment fee (usually a couple of hundred dollars)
Early repayment costs can also be known as
- Early repayment penalties
- Early repayment economic costs
- Early repayment interest adjustments
- Break costs or break fees
How is the early repayment cost calculated?
Lenders will typically finance your home loan on the wholesale market with a fixed maturity date. At the time you switch loans or repay your loan early, the bank will use the Bank Bill Swap Rate (BBSR) or BBSW to calculate your early repayment cost. Current BBSRs are displayed on the homepage of the Australian Financial Markets Association and the ASX website.
The BBSR is the interest rate charged on wholesale fixed rate borrowings for banks. It is a floating market, so rates change daily, if not by the minute. They use this measure because it is the most transparent indicator of the cost of funding for your loan.
Lenders compare the BBSR when you originally entered the loan and compare it with the BBSR at the time you break. As BBSRs use specific time periods, such as a three year maturity BBSR, an early repayment cost will be calculated against a BBSR of the same time period that you have left on your loan. So if you have one year left on your fixed home loan, your original BBSR will be calculated against the one year BBSR on the day you break.
*This diagram is an example only.
So, if you decide to break a three-year fixed loan at the start of the third year, your lender will compare the original market swap rate with one-year market swaps (as that is the period remaining on the loan). If the current BBSR is less than at the time of fixing, the customer will have to pay the difference on the amount that was agreed to be paid for the remaining term – as your lender has an obligation to keep up their repayments on their wholesale funding for your loan. They have an agreement to pay their wholesale lenders a fixed amount – whether those lenders are on the market or an internal lending arm. These charges compensate for the estimated cost in lost interest and administration time.
Breaking a fixed loan isn't always a situation where large break payments result.
One quick indicator is the home loan market. If all the interest rates currently on the market are more expensive than your current fixed rate home loans, the chances are that your lender will gladly let you off without any repayment penalty – as they can make more money out of your exit.
Check out the two very different scenarios below to see when you might be facing a huge repayment penalty, versus when breaking your fixed rate home loan might be worthwhile.
Fixed interest loan basic early repayment adjustment scenario 1
Outcome: large early repayment cost
|Loan length||25 years|
|Fixed period||3 years|
|Repaid when?||May 2013 (2 years into a 3 year fixed period)|
|Interest rate of loan||8.7% p.a.|
|1 Year of repayments remaining||$34,800|
Early repayment cost calculation
|3 Year BBSR (May 2011)||7.59% p.a.|
|3 Year fixed interest rate (May 2011)||8.80% p.a.|
|1 Year BBSR (May 2013)||2.65% p.a.|
|Difference between original BBSR and BBSR at break||4.94% p.a.|
|Difference/original BBSR (4.94/7.59*100)||65.1%|
|1 Year of repayments remaining||$34,800|
|Early repayment adjustment (65.1%x $34,800)||$22,645|
|Plus exit fee||$400|
|Total early repayment adjustment||$23,054|
In the above example, a borrower has broken a three-year, interest-only home loan at the start of the final year. The borrower has to pay the large 65% difference in the interest rate that was agreed to be paid in the final year. So, the borrower must pay $23,054 in early break costs including fees.
Fixed interest loan basic early repayment adjustment scenario 2
Outcome: no early repayment cost
|Loan length||25 years|
|Repaid when?||Feb 2011 (4 years into a 5 year fixed period)|
|Interest rate||7.5% p.a.|
|Original Market Swap Rate (MSR)||6.39% p.a.|
|MSR in February 2011||6.59% p.a.|
|Difference between original and 2011 MSR||-0.2% p.a.|
|Market interest rate 5 year fixed interest loan February 2011||8.80% p.a.|
|Early repayment adjustment||$0|
|Plus exit fee||$400|
|Total early repayment adjustment||$400|
This scenario is a 5 year fixed home loan which began in February 2009. It is likely in this case that no early repayment cost will be charged to the borrower.
Why? The original market swap rate is 0.2% p.a. less than at the time the borrower broke the fixed loan. The lender can earn more money on the market now than the original loan agreement.
So by breaking this fixed home loan, the borrower is freeing their lender to make more money by taking advantage of higher lending interest rates on the market at the time the customer broke the loan.
Essentially the lender can use the original wholesale funding agreement to lend money to new home loan borrowers at a higher interest rate than they were receiving under the original agreement.
If you are thinking about breaking a fixed home loan, your first step is to contact your lender and request a quote for breaking your loan inclusive of the early repayment cost. Then compare the interest costs of a potential new loan.
You should also weigh the pros and cons of fixed and variable rates when making your decision to switch.
Compare how much you'll save by switching to a lower rate
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