While a fixed-rate home loan provides certainty and stability with repayments, it does have limitations that can restrict the changes you can do with your loan. If you break these limits, you will end up paying extra costs.
These extra costs are also known as break fees. Take note that break costs are different from mortgage exit fees and discharge fees. Break costs are exclusive to fixed-rate mortgages.
When are you charged break costs?
When you are on a fixed rate, your repayments will be the same for a certain period of time. This, however, represents a double-edged sword — while you are protected against sudden rate hikes, you will not be able to take advantage of rate cuts when the Reserve Bank of Australia eases the monetary policy.
There are several instances which can trigger your lender to require you to pay break costs. Banks will typically charge break costs if you prepay part of or your entire loan before the end of your fixed-rate period. When you exceed your prepayment threshold, you will also be required to settle break fees.
You will also incur break fees when you decided to switch or refinance to another product while you are still on a fixed term.
If you sell your property during your fixed-rate period, you will also have to pay break costs, especially if your mortgage is not portable.
How are break costs calculated
Lenders usually borrow money from the wholesale money markets through the Bank Bill Swap Rate (BBSR), which is locked in at the same time as your fixed rate. As you sign a fixed-rate deal with your lender, they also enter a contract with a third party to lock in their funding costs at a fixed rate.
When you decide to break your fixed-rate term, your lender will likely make a loss, which they will end up passing to you.
To calculate how much you will be charged, lenders take into consideration the difference between the wholesale rates at the time when you entered a fixed contract and when you decide to terminate the fixed term. The difference will then be multiplied by the loan amount and the remaining term of the loan.
The calculation of break costs is complicated, as it involves several variables. You can reach out to your bank to know how they calculate break costs. However, here's a simple formula from the Bank of Queensland that can give you an idea of how break costs are calculated:
Break Cost = Loan amount prepaid x interest rate differential x remaining term
Let's say you have a $450,000 mortgage on a five-year fixed term. At the time that you applied, the five-year wholesale rate was 4.5%. After three years, you decide to break your fixed-term to refinance your loan. By this time, the BBSR has declined to 3.45%.
Using the given figures above:
Break cost = $450,000 x (4.5% - 3.45%) x 2 years
This will yield an approximate break cost of $9,450.
How can you avoid break costs?
When you apply for a home loan, you will have a choice to lock in the interest rate for a certain period of time, typically up to five years. The simplest way to avoid break costs is to stick with your fixed term. You have to plan ahead and consider not just your finances but also the market conditions and projections, especially if your main motivation of fixing your mortgage is the possibility of rate hikes.
Here are some other ways on how you can avoid break costs:
1. Shop for a variable loan
Given the low-rate environment, it would make sense if you explore variable-rate loans. Unlike a fixed-rate home loan, a variable mortgage allows you to customise your loan according to your own preferences. It will allow you to make additional payments and access loan features that will help you save in the long-run. You will also have the chance to refinance and make some changes to your loan without having to worry about fees. Take note, however, that in some cases, variable rates are higher than fixed rates. Check out the most competitive variable home loans here.
2. Consider getting a split loan
Split loans allow you to enjoy the best of both worlds — a portion of your loan is protected against rate hikes while the other has the flexibility of a variable rate. When you get a split loan, you will be able to enjoy loan features that a standard fixed-rate loan does not offer, such as offset accounts and redraw facilities.
3. Get a portable home loan
If you think there is a chance that you will sell your home while you are on a fixed rate, make sure that you ask your lender about the portability of your loan. This feature allows you to transfer your loan onto a new property. Portability will also help you avoid other costs, such as establishment fees.
Know more about break costs by reaching out to a home loan specialist. Go to Your Mortgage Broker