If you’re starting to feel your mortgage no longer ‘fits the bill’ and are thinking about switching, you need to be aware of the string of exit fees on the way out
Times are getting tough in Australia. Just ask any homebuyer that has tried to switch loans and lenders in the last six months.
According to a report by the Australian Securities and Investments Commission, Australian homebuyers face some of the highest “early mortgage termination” fees in the world — as well as a complex array of other fees and charges.
But it’s not all bad. Knowing a bit about exit fees, why you pay them and how to avoid paying too much could be the key to reducing your overall fee amount and making a much smoother transition to your new loan and/or lender.
The first time that many borrowers hear about exit fees is when they are slugged with them. This could mean a move from a fully-featured standard variable loan (with features never completely utilised) to a no-frills loan. This could also be a move from a basic loan with minimal features to one with every feature known to man (with the rationale that the new loan will better suit the lifestyle of the borrower). Some borrowers believe that chasing the lowest interest rate each year will save them money. Once you factor exit fees into the equation, you can usually forget this strategy!
Whether they go by the name of an early-termination fee, settlement fee, loan-termination fee, facility-termination fee, documentation/administration fees or ‘break fees’ (in the case of fixed rate loans), there’s no denying that exit penalties are shifty assassins on the end of a mortgage – and they do inflict quite a lot of financial damage.
Most exit fees are structured over four years, either on a decreasing dollar amount, or a decreasing percentage. These fees are basically a consolation prize for the lender if you decide to refinance, terminate your loan or pay it off early. Depending on which category you fall into, chances are the fees will differ in title, but not much else. You still have to pay them and there’s a separate reason for each.
Why do exit fees exist?
While some of the reasons that exit fees exist are obvious, other reasons aren’t as simple. The first and most obvious reason is that once a lender has signed you up as a borrower, they want to keep you.
It has been estimated that if you divide the number of dollars spent on advertising by each major bank in a year by the value of loans they write in that year, you can get a figure close to $1,000. Lenders refer to these costs as ‘origination costs’. They try to recoup these in a number of ways. In the past, one of the most important of these has been the upfront fee.
But the home loan market has become more competitive now than it has been at any time in the past and some lenders sometimes ditch their upfront fees during special promotions in an effort to keep new customers coming in the door. This means that once a lender has you as a customer, they want to keep you as long as they can in order to break even, let alone make a profit from you.
Most lenders these days offer some sort of cheap introductory rate. Lenders, not surprisingly, don’t offer honeymoon rates out of the goodness of their hearts. They do it to get you signed up as a customer. They are also likely to see this ‘honeymoon’ rate as a cost that they have to recoup. If you bail out of the loan early, they can’t recoup this loss. That is, of course, without the use of exit fees.
Back to basics
Like honeymoon introductory loans, basic variable loans are cheap. Because they are cheap it takes the lender longer to show a profit on them. It is for this reason that basic variable loans can pack a bit of a wallop if you want out before the lender has made a quid out of you. Some basic variable loans won’t allow you to make additional repayments or might only allow you to adjust your repayments once a year – now that’s what I call basic!
There are a number of ways in which lenders work out what it is going to cost you to exit your loan. Depending on the type of loan you have, how long you have had that loan, and which contract you have signed at which time and with what type of exit penalty applies to that loan, the cost of exiting a $100,000 loan can range between nothing and several thousand dollars. These penalties can be based on a number of factors. Among others they include:
1. The lender’s cost of funds
A lender will generally have borrowed the money that it lends to you either through deposits made by other customers or through securitisation. This means that they have to make enough out of you to service their loan and make a profit as well. If you bail out of your loan early, your lender might have to reinvest the money that you repay elsewhere to make money. If the rate that they can get for this money on the open market is less than you were paying them, the lender can be out of pocket and hit you with a penalty based on this difference.
Like anyone else, a lender is working to a budget. If they have signed you up and are expecting to make a certain amount of profit out of you, they may well lose a proportion of this profit if you exit your loan early. They want their profit any which way and are likely to hit you up for it.
3. An arbitrary sum
Some lenders will simply hit you with a flat fee if you want to exit your loan within a certain period. This is usually based on the amount that they have calculated it has cost them to sign you up in the first place.
The question you should ask yourself right now is ‘What sort of exit penalty applies to my loan?’ – for the one you are intending to buy or the one that you currently have. To answer this question we will take a quick run through the ‘can of worms’ that is exit penalties.
1. No fees
If you have a loan with no fees, congratulations, you’ve obviously done your homework or got lucky. Before the sub-prime crisis hit the mortgage market, there were a handful of lenders who claimed to offer their customers loans that include standard variable and fixed rate loans without exit fees. However, you may find that this deal has now disappeared or has become scarce.
A flat fee is usually levied on borrowers who are exiting a standard variable home loan. This fee can range between $200 and around $2,000. This fee is usually based on one of two things: either the amount that the lender estimates that it cost them to sign you up in the first place or the amount it costs them to do the administration on closing out your loan. Many lenders also build statutory and legal fees (usually around $150) into this fee.
3. An interest penalty based on a number of months’ interest
Interest penalties are perhaps the most common type of exit fees. Interest penalties are based on:
- a number of months’ interest on either the amount outstanding at the date of exit
- the amount you borrowed originally
On variable loans, penalties often work like this:
|If you exit before...||You pay...|
|End of first year||Three months' interest|
|End of second year||Two months' interest|
|End of third year||One months' interest|
|If you exit before...||You pay...|
|End of second year||Three months' interest|
|End of third year||Two months' interest|
|End of fourth or fifth year||One months' interest|
If you are on a variable rate loan the interest penalty will usually be based on the prevailing interest rate at the time of exit. So if interest rates have risen (which is often the reason that borrowers want to switch loans in the first place) you will be worse off than if interest rates have fallen or remained stable.
Keep in mind that while it is most common for the lender to charge you interest on the amount outstanding on your loan when you get out of it, some will charge you on the full amount that you borrowed initially. This is not nice.
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 12 to 36 months and are then rolled into a standard variable rate. They have been as cheap as 5% recently – the equivalent of more than 1.6% discount from the bank’s standard variable loans. Often they have no establishment fees, and because they are similar to standard variable loans they used to be offered without penalty on 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 its end of 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, often keeping you locked into a plain ol’ variable loan for up to five or seven years!
Some work like this:
If you pull out before...
You pay a penalty of...
|One year is up||Three months' interest|
|Two years are up||Two months' interest|
|Three years are up||One months' interest|
For example, the penalty for paying out a mortgage with $100,000 owing at the time, at a rate of 7% within one year of taking it out, will cost you $1,750.
Loan amount: $100,000
Interest rate: 7%
Exit cost if you pulled out within one year: $1,750 ($1,000 x 8% x 3 months/12)
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. It can also be based 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 more painful than if they have been stable or fell.
But it can get worse, like this:
If you pull out before...
You pay a penalty of...
|Two years are up||Three months' interest|
|Three years are up||Two months' interest|
|Four or five years are up||One months' interest|
Interest penalties – The bottom line
Assumptions: A principal and interest variable loan is paid out after two years
Interest rate: 8%
Term: 25 years
Penalty: Two months’ interest on balance outstanding
Outstanding balance at two years: $97,273
Interest rate per day (as a decimal): 8/365 = 0.0219178%
Interest per day: $21.32
Therefore, interest penalty: 60 days x $21.32
On their variable loans, if you want to get out before the first five years are up, some lenders charge one month’s interest at the prevailing rate of interest at the time of exit, not on the remaining principal but on the original amount of the home loan.
If you pull out of a 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.
Fixed rate penalties are calculated based on the following:
This is 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% for five years and the current interest rate is 6%, there is a 2% interest rate differential. If you exited this loan early you would have to pay the interest differential of 2% for every year of the fixed term remaining.
This can really hurt.
If, for example, you have two years of the 8% fixed term remaining on a $100,000 loan you can expect to pay around $4,000.
Loan size: $100,000
Fixed term: 5 years at 8%
Current interest rate: 6%
Interest rate differential: 2%
Exit cost within three years: $4,000 ($100,000 x 2% x 2 years)
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.
Cost of funds
If, for example, the bank itself took out a fixed loan at, say, 8% to finance your fixed loan at, say, 10% the bank needs to ensure that it does not lose money by continuing to pay out its own loan at 8% while receiving less than 8% 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 marketplace and the actuarial calculation.
Before you enter into your loan make sure you know, in writing, how the penalty fee – expressed in real dollars not in vague terms – is worked out.
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% with two years of a fixed term to go, your contract could force you to pay two years’ interest at 8% to exit the loan. In this case, $16,000 ($100,000 x 8% x 2). If you are unlucky enough to have a loan with that type of penalty, think again. Better still – look before you leap.