On the Way Out

By Your Mortgage

Exit fees are the costs you face to get out of your home loan. They're a fact of life.
They can be complicated, confusing and expensive.
Your Mortgage looks at exit fees and what they could cost you.

When shopping for a new loan, many borrowers fail to think carefully about what would happen should they exit that loan early. The savvy borrower covers all bases before, during and after signing with a lender.

As home loan conditions and features can vary quite dramatically between lenders, and interest rates continue to change, at some stage you could be looking at the possibility of getting out of your loan earlier than you'd anticipated.

The big switch
For most of us, an early exit from a loan occurs because we've decided to refinance elsewhere. Refinancing usually happens because there's a better deal elsewhere. In recent months, as astute readers will have noticed, we've had a price war in home loan lending.
The major banks have dropped their standard variable rates to around 6%. This has made the prospect of refinancing very enticing, especially for those borrowers with fixed rate loans.
But before you pick up the phone to organise a new loan, it's worth considering that switching to a cheaper mortgage might cost you more than your current loan. How could this be? The answer lies in the exit fees.

Exit fees - a potted history
Before we look at the intricacies of exit fees - and exit fees are more like a minefield than a maze - we need to go through some background information.

Loan types
Basically, there are four types of loans available on the mortgage market at the moment. They are:
• Capped, short-term fixed and discounted loans
These so-called 'honeymoon' loans are designed to attract new customers to a lender. They offer a cheap rate early in the loan (usually for the first 12 months or so) and then generally roll over into a standard variable loan. That is, they roll over to a 'default rate'. Note that these types of loans aren't available to existing customers of the lender.

• Standard variable loans
Usually, these are the most flexible type of loan available from any given institution. Standard variable loans often have features such as redraw facilities, offset accounts and other attractive bells and whistles. They're also usually the cheapest to exit and the most expensive in terms of interest rate.

• Basic variable loans
As the name suggests, these are similar to the standard variable loan but without the extra features. Basic variable loans are becoming increasingly popular with borrowers due to their cheaper rates, which are usually around 1% lower than that standard variable loans.

• Fixed rate loans
Fixed rate loans, by their very nature, will lock you in for a fixed number of years. This term is usually two to five years and they usually switch or 'default' to the standard variable rate after this time.
This type of loan is growing in popularity at the moment. But getting out of a fixed rate loan before the term is up can be a very expensive process indeed. More on this later.

Why do lenders have exit fees?
There are several reasons for the existence of exit fees, which may or may not be obvious. Essentially, once a lender has signed you up as a borrower, it wants to keep you (and your money); exit fees are meant to stop you from going elsewhere.

Origination costs
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 is more competitive now than ever before, so many lenders have ditched their upfront fees in an effort to keep new customers coming through the door. Instead, the lenders are recouping these costs through the exit fees.

'Honeymoon' sweeteners
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're also likely to see the 'honeymoon' rate as a cost that they'll recoup when you revert to a standard variable loan. If you bail out early, they won't be able to recoup this loss, so this is another reason for exit fees.

Basic variable loans
Like 'honeymoon' introductory loans, basic variable loans are cheaper. Because they're cheaper it takes the lender longer to show a profit on them. It's for this reason that basic variable loans can pack a bit of a wallop if you want out before the lender has made its quid out of you.

Paying the penalty
There are many ways that a lender can use to work out what it'll charge you to exit your loan. About 34 ways is as near as we can establish!
Finding out which one applies to you can be a bit convoluted. In fact, depending on the type of loan you have, how long you've had it for, which contract you've signed and when you signed it, and which type of exit penalty applies to that particular loan, the cost of exiting a $100,000 loan can range between nothing and several thousand dollars.
The factors that the exit fee penalty is based on include:

• The lender's cost of funds
A lender will generally have borrowed the money that it lends to you from somewhere else. This means that it has to make enough out of you to service its loan and make a profit.
If you bail out of your loan early, your lender might have to reinvest the money that you've repaid elsewhere.
If the rate that it can get for this money on the open market is less than what you were paying it, the lender can be out of pocket and charge you a penalty based on this difference.

• The lender's loss of profit
Like anyone else, a lender is working to a budget. If it has signed you up and calculated that it will make a certain amount of profit out of the money it lends you, it may lose a some of its profit if you exit your loan early.

• An arbitrary sum
Some lenders will simply charge you a flat fee if you want to exit your loan within a certain period. This is usually based on the amount that a lender calculates that it originally cost to sign you up.

The question you need to get an answer for is: "What sort of exit penalty applies to my loan?" This is equally relevant for the home loan you're intending to take out as the one you currently have.
To give you background information, we'll take a quick run through the different types of exit penalties.

No fees
You'd be hard pressed to find a lender who charges no fees if you exit the loan within three to four years. However, after four years, some lenders including Newcastle Permanent, One Direct and Australian Mortgage Options drop their exit fees as well as their deferred establishment fees.

A flat fee
A flat fee is usually levied on borrowers who are exiting a standard variable home loan. The fee can range between $100 and around $1,500.
This fee is usually based on one of two things: either the amount that the lender estimates that it cost them to get you through the door and sign on the dotted line or the amount it costs them to do the administration on closing your loan. Many lenders also build statutory and legal fees (usually around $150) into this fee.

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, or
• the amount you originally borrowed

These fees are most common on variable loans, especially where there's a cheap introductory rate, but can also be attached to fixed loans.On variable loans they often work like this:
If you're 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) you'll be worse off than if interest rates have fallen or remained stable.
Keep in mind that while a lender usually charges you interest on the amount outstanding on your loan when you exit it, some will charge you on the full amount that you borrowed initially.

Interest differential penalties
Interest differential penalties (also known as early termination interest adjustments and economic costs/benefits) are perhaps the hardest of all exit fees to understand.
These penalties mostly occur for fixed rate loans and usually take a number of factors into account.
As their name suggests, interest differential penalties are based on the difference between interest rates at the beginning of the loan and at the time when you say goodbye to your loan. Where it gets complex is in working out which interest rates the lenders are going to use in their calculations.
Some lenders work out your exit costs based on subtracting the current fixed rate from the rate at which they lent you the money. Say, for example, you borrowed at a fixed rate of 9% and the fixed rate has fallen to 7%. The lender in this case might charge 2% (9% less 7%) on the amount outstanding for the remaining term of the loan. This can be quite a large amount of money.
Other lenders base their interest differential on the difference between their cost of funds and the rate at which they can reinvest the money that is repaid to them early. For example, if a lender borrowed the money it lent you at 9% but can only reinvest at 8% on the money market, it might charge you 1% for the remaining term of the loan.
Other lenders might base their interest differential rate on the difference between your fixed rate and the amount they can get on the wholesale money market. In some cases this can cost you a big chunk. Say you have a fixed loan at 9% that you want to get out of.
If your lender bases its interest differential calculation on the money market rate (say, 6%) you could be up for a hiding of 3% per annum on what you still owe your lender for the remainder of your fixed term.
If interest rates rise between the time when you take out your loan and when you leave, the exit penalty may turn out to be a benefit. Some lenders will pass this benefit on to the borrower. That is, you may end up paying off less than the amount you actually owe.

So is it worth it?
If you're considering switching, sit down and work out exactly what it would cost you to get out of your loan. Then add to this amount the expense of getting a new loan. Remember to include all establishment fees, valuation fees, legal fees and stamp duty if applicable.
Next, work out exactly how much you would pay in interest and other charges on your new loan.
Once you have a firm idea of the costs of switching, work out the savings that you'll make on your new loan. Start off with the first 12 months and look ahead in 12-month increments until the savings start outweighing the cost.
Keep in mind while you're doing these calculations that if the new loan you're considering is a fixed loan you may find yourself wanting to get out of it at some time in the future.

Not switching - but still saving
After you've done all the sums you should have a pretty clear idea of whether it's better to switch to a cheaper loan or not. If the answer is no and you decide to stay with a more expensive loan, don't despair. All is not lost.
There are still ways to make sure that you get the most out of your home loan by making the one you've got work best for you. Check out the article '7 ways to shred your mortgage' on page 58 for tips on paying off your mortgage faster. YM