Exit fees: Are you overpaying?
When leaving (or getting out of) your existing home loans, you may be subject to exit fees. They can be complicated, confusing and an expensive fact of life. We take a look at what they are likely to cost you.
When shopping for a loan, many new borrowers neglect to carefully look at what is going to happen if they exit it.
For many of us, it might seem a little like planning for a divorce as we plan our marriage. Or worrying where the kids are going to live when they leave home while they are still in the maternity ward.
Humans aren't like that. We try to be positive, look at the bright side and accentuate the positive. And in our home loans affairs we often pay for this attitude in spades. But the smart borrower covers all bases before, during and after signing with a lender. As we have seen in recent years, home loan conditions can change quite a lot over time.
This involves looking at the possibility of getting out of your loan early.
Positive thinking is reckless
As we said, when we enter into a loan we think positive! We're moving into the home we have always really wanted and isn't it great? Look at the size of the land, the garden, and space for a pool! No paint job needed, but maybe we will have to get a new kitchen. But let's sign the documents and move in! We're not sure what the plan is, but we're making good speed.
But beware, your lender is thinking: "Is the house sound enough to lend on? Can I make a profit on this deal? Is my margin big enough? Will this couple keep paying me for the next 25 years? And what if they default!? I’d better figure out how to keep them in the loan and make it just a little awkward for them to leave."
There's a real difference in attitude here. The borrower is gungho, thinking: "gimme the money, I'm buying a home." But the lender is negative, and is trying to figure out what to put into the paperwork and the loan documentation. They want to make sure that if things go wrong, the borrower can't run away and cause them too much pain.
Before you can understand the exit fee game you need to bone up on what sort of loans generally have what sort of exit fees.
Let's start with the main types of loans. There are really only three main types of home loan rates in Australia, ones with:
1. Capped, short-term fixed or discounted variable rates
Although the interest rate on these loans is initially cheap, in most cases in 12 months or so their terms and conditions revert to those of the...
2. Plain ol’ vanilla variable rate
These are usually the most flexible loans and most often have the least expensive exit costs – unlike the most expensive loans to get out of, namely...
3. The longer-term fixed rate loan
These loans will by their very nature tend to lock you in. They usually run for one, three or five years. They usually switch to the variable rate after the fixed part of the loan term expires.
To these three you can add loans which have a rate linked to some sort of other rate, like 90-day bank bills.
Why do exit fees exist?
A quick aside is necessary here so that we might understand why your lender goes all weird on you when you say you want to get out of your home loan. There are a few obvious reasons.
• Once they have you as a customer, they want to keep you. It has been said that if you divide the dollars spent by a major bank on advertising a year by the value of loans they sell in that year, you can get a figure around $600. That is, it costs a bank $600 to sign you up in advertising costs alone. Mortgage managers call these 'origination' costs. Lenders often try to recoup this money in upfront fees. But in today's competitive market, fees are often abolished or non-existent.
• If a lender gives you a honeymoon break at the front of a loan it will see this as a cost or at least as an opportunity forgone. It costs them interest dollars to get you in the door and they hope to get it back over the duration of the loan – from you. If you are not there after a couple of years, they can't do that, can they?
Sources of funds
Generally speaking, banks use more costly money as a source for their fixed term loans than other lending institutions. Their cheapest money – the lower interest bearing accounts that granny has with the bank – will be used more often than not for variable rate loans. Why do they do this?
If they use granny's money to fund variable loans it is easier for them to 'margin manage' their loan portfolio. If deposit rates need to go up, they simply raise their variable home loan rate to maintain the 'spread' between money borrowed and lent.
Banks and mortgage managers will often buy 'term money' wherever capital coagulates around the globe – maybe in the wholesale market, or even somewhere in Europe. Selling fixed home loans and buying fixed money to cover it is called 'matched funding'.
Most fixed home loans are 'matched'. They don't like you to get out of fixed rate loans unless they can get out of their own fixed rate loans. So the penalties for getting out of these loans are usually on the tough side. They can also be on the downright rough side.
Wait, we want to adjust you
Getting out of any home loan will cost you something, even if it's only a government fee. But government fees are small change compared to what your lender can hit you with if you don't read the fine print which covers your exit from your loan.
When it's time to get out of your loan you might hear a couple of terms which might cause you a little fear and discomfort. Take the banking terms 'Early Termination Interest Adjustments' or 'Deferred Establishment Fees', for instance. You might also run into the term 'break costs', which are roughly the same thing. You are especially likely to run into these terms when you are trying to exit a fixed rate loan.
Your lender will work out your break costs and can charge you an exit fee if:
• you want to exit your fixed loan
• it costs them money
• they have you covered by their paperwork
The fee will be calculated in a number of ways. Back to this in a minute.
Out of variable
Lenders can charge you a fee even if it doesn't cost them money.
As we have already indicated, banks (and for that matter, other lenders) have been playing hard at getting and/or keeping market share for some time now. To try to get and keep more customers than their competitors they have used a few marketing devices, not the least of which is the 'come-on' rate loan.
These offer short-term start up rates which look attractive to the uninitiated. They are also known as ‘honeymoon loans’ or discounted variable rate loans. Usually they are a cheap rate which lasts for six or 12 months and are then rolled into a standard variable rate. Often they have no establishment fees.
Because they were similar to standard variable loans, they had no penalty for exiting them.
Now, some naughty people took advantage of this no exit penalty position by taking up the cheap introductory offer and pulling out of it as soon as the cheap rate neared the end of its term. They would then jump into another cheap, introductory, no-front-end-fee mortgage and try to repeat the procedure.
As a consequence, the lenders wised up and many have now put exit penalties on lots of their products.
Some exit fees work like this:
For example, the penalty for paying out a mortgage with $100,000 owing at the time at a rate of 5.76% pa within one year of taking it out will cost you $1,440 ($100,000 × 5.76% pa × three months).
Your exit penalty can be based on the interest rate you are paying at the time of your exit, not on the rate operating at the time you took out the loan. And it is on the balance you owe at the time you pull out. In other words, if rates have risen since you took out your loan it’s going to be more painful than if they have been stable or fell.
But it can get worse. Like this:
Some will charge you on the full amount borrowed, not the principal balance outstanding at the time of the exit.
Exiting fixed loans
If you pull out of fixed rate loan, you can cop it in a number of less than delightful ways. All of them aim to ensure that the lender does not suffer a financial loss.
Whichever way you go, you will probably incur what it called a 'discharge fee' which might be about $150. This fee is basically charged to cover the lender's legal costs.
There will usually be other penalties. One is based on interest differential – the difference between your interest rate at the time you took out the loan and the rate prevailing when you exit.
For example, if you took out a fixed term loan at 8.5% for five years and the current interest rate is 5.76%, there is a 2.74% interest rate differential (8.5% – 5.76%). If you exited this loan early you would have to pay the interest differential of 2.74%, or the equivalent of $2,740 for every year of the fixed term remaining. If you have three years remaining, this equates to $8,220. This can really hurt.
Another way you will be charged is if, for example, you have two years of the 8.5% fixed term remaining on a $100,000 loan. You can expect to pay about $5,480 in early exit penalties ($100,000 × 2.74% × two). Not surprisingly, it’s really a little more complex than this. The bank will plug the interest rate differential into a complex actuarial calculation, which takes into account the time value of money, in order to come up with the exact penalty amount.
Lenders' cost of fund
The other way of working out the interest differential is based on the bank's cost of funds.
If, for example, the bank itself took out a fixed loan at, say, 7% to finance your fixed loan at, say 9%, the bank needs to ensure that it does not lose money by continuing to pay out its own loan at 7% percent while receiving less than 7% from you. One way of doing this is for the bank to refinance its own loan, which means that they may have to pay an interest penalty themselves. They will pass this on to you.
The lender may describe these types of penalties in a number of ways – as a prepayment interest rate adjustment, as the difference between the cost of funds, as an interest rate differential penalty or just as an actuarial calculation. The way in which they are calculated varies between lenders and between individual mortgages. The penalty will depend on the interest rate of your fixed loan, the way the lender financed the loan, the prevailing interest rate in the market place and the actuarial calculation. Before you enter into your loan make sure you know, in writing, how the penalty fee – expressed in dollars, not in vague terms – is worked out.
Full interest penalty
There is yet another way of calculating the exit cost on a term loan. It's a horror and it's called full interest penalty: this is the full amount of the interest due on a fixed rate mortgage if it were continued for the full duration of the original term.
On a $100,000 mortgage at 8.5% with two years of a fixed term to go, your contract could force you to pay two years interest at 8.5% to exit the loan. In this case it would be $17,000 ($100,000 × 8.5% × two). If you are unlucky enough to have a loan with that type of penalty, think again before exiting it. Better still, look before you leap.
Exit fees: Are you overpaying?