When choosing a home loan, you’ll need to choose between having a variable or fixed interest rate.

What you choose will depend on many factors, including your own circumstances and the outlook for interest rates (which can be very difficult to forecast).

See also: How to choose between a fixed-rate or variable-rate home loan

But before you opt for a fixed interest rate, it’s important that you’re aware of break fees.

What are break fees?

Break fees, or break costs, are charged by your lender if you leave your fixed-rate home loan before the end of the fixed-term - whether you’re selling your home, refinancing, or simply wanting to jump to a better interest rate, even if it’s with the same lender.

Most lenders will charge break costs. They can also apply if you pay off more of your loan than your fixed repayment schedule, although most lenders will allow you to pay a small amount extra each year without being hit with a penalty.

Break fees are set by individual lenders and take into account wholesale funding rates at the time you took out your fixed-rate loan and at the time you want to break it. They’re also dependent on how far into the fixed-term contract you are. Each lender will have its own method of working out how much you’ll be up for in break fees - and you may be shocked at the cost.

How much do break fees cost?

This is where it can get tricky. Lenders don’t always disclose how their break fees are calculated and each lender can calculate them differently. But in most cases, the borrower will usually have to repay the bank’s cost of doing business. The simple formula is generally expressed as:

Loan amount prepaid x (Interest Rate Differential) x Remaining Term = Break Cost

The ‘differential’ is the bank’s wholesale funding rate at the time you took out your loan, minus the bank’s wholesale funding rate at the date you broke your contract.

The wholesale funding rate is what the lender pays in interest on the funds it lent you. It’s also referred to as the Bank Bill Swap Rate, or BBSW.

However, some lenders might also set their own wholesale funding rates. These rates can vary daily so the end fee can change daily as well. Most lenders ask that you contact them so they can give you an accurate picture of the break cost you’ll face.

Just for fun, let’s look at the formula Westpac uses to calculate its break costs:

∑[i*Badj +Badj -Badj] * dƒt -CB-∑[i*Bnew +Bnew -Bnew] * dƒ t-1 t-1 t t-1 t-1 t -(CB-P)

So, you get the picture. It can be complicated.

Case Study

But that shouldn’t deter us from looking at a simplified example. Dea L’Brècher has a fixed-rate home loan but is leaving the country and has decided to sell her home and pay out the loan.

She’s leaving two years into her three-year term, after having borrowed $400,000 over a 25-year term. She’s at a café, and being the savvy duck she is, she looks at the BBSW rates and jots down a calculation on her napkin:

  • At the time of terminating the loan, the three-year BBSW is 2%, while two years ago it was 3.5%, for a differential of 1.5%.

  • After two years, there is $368,000 remaining on the principal of Dea’s loan.

So, the simple version of the formula would be $368,000 x 0.015 x 1 = $5,520. In this case, Dea would have to pay more than $5,500 on top of the sum to pay out her loan.

If she’d stuck it out for just one more year, she could have avoided the penalty.

The above calculations are for illustration purposes only. Note: there may be other administration fees for breaking your fixed term early. As always, contact your lender if you have queries.

What if the rate goes up?

You may have noticed that the above calculation assumes interest rates headed lower during the fixed-rate period.

If you’d locked in at a low rate and market interest rates had gone up in the time you wanted to terminate your loan, you might not have to pay any break fees (although you can expect to be hit with other fees, such as exit or discharge fees).

This is because the lender will be only too happy to relend the money it had allocated to you to someone else at a higher rate. In this case, the lender stands to make a profit from you repaying your loan early.

How to avoid break costs?

The fool proof way to avoid break costs is to do your best to serve out the fixed-rate term. If you need to sell your home or refinance the loan in this time, you will just have to cop the penalty.

If you’re looking to refinance the loan to jump to a lower interest rate elsewhere on the market, ensure you account for the break costs you’ll likely face. It may make the exercise costly and not worth your while.

See also: 11 things to consider before refinancing your mortgage

But, from time to time, some lenders may offer refinancing rebates which effectively lower the cost of their break fees if you refinance with the same lender. Cashback offers may also cover some or all of the cost of breaking your fixed-rate loan.

See also: Home loan offers and deals

But if you break a fixed-rate loan, and rates have dropped considerably in the time since you signed up to it, you can expect to get whacked with hefty break fees. Generally speaking, the longer the remaining fixed-rate period and the bigger your loan, the more you’ll pay in break fees.

Savings.com.au’s two cents

Fixing your home loan rate can be a tempting prospect, particularly when fixed rates are considerably lower than the variable rates on the market. But financial markets are highly unpredictable, even to so-called experts.

As with most contracts, there are penalties for breaking a fixed-rate home loan. Even on a simple $400,000 mortgage, you could be paying more than $5,500 to break the loan agreement. It’s not uncommon for those with much larger loans to be looking at paying tens of thousands of dollars in break fees.

If you’ve opted for a fixed-rate loan, it’s probably for good reason - whether that be a competitive rate or for cash flow certainty. Generally, it’s recommended you serve out your fixed-rate term and prepare for the time when you can look around for a better rate, or a more flexible loan to suit any change in your circumstances.

At the end of the day, the money you save by hanging in there is better in your pocket than your lender’s.

Photo by Ben White on Unsplash

Disclaimers

The entire market was not considered in selecting the above products. Rather, a cut-down portion of the market has been considered. Some providers' products may not be available in all states. To be considered, the product and rate must be clearly published on the product provider's web site. Savings.com.au, yourmortgage.com.au, yourinvestmentpropertymag.com.au, and Performance Drive are part of the Savings Media group. In the interests of full disclosure, the Savings Media Group are associated with the Firstmac Group. To read about how Savings Media Group manages potential conflicts of interest, along with how we get paid, please click through onto the web site links.

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