With the cost of borrowing money on the rise, it may seem prudent to lock in a home loan on a fixed rate. Or perhaps you already have a fixed-rate home loan and are looking to break out of that in order to lock in a new, much lower fixed rate before rates go up again.

But mortgage brokers around the country say there are hidden traps creeping into fixed-rate home loans. One of the key traps to watch out for is the break fee, which can cost thousands of dollars. So before you consider breaking out of an existing fixed-rate home loan, you’ll need to consider these fees – which, in addition to being expensive, can be hard to work out.

Peter Cooper, managing director of Brisbane-based Cooper Financial Connections, says borrowers need to research thoroughly on how banks calculate break fees before committing to a loan. He also notes that there needs to be much greater transparency from the banks.

“When explained to the borrower, most understand the need for a break fee. However, they are generally surprised at the size of the compensation sought by the bank,” Cooper told the Australian Financial Review.

“Over the years, there has been greater emphasis on disclosure of fees and charges so a borrower can make an informed decision when comparing loan products, but this trend to greater transparency does not appear to apply to banks disclosing break funding calculations.”

How break fees are calculated

There are four main components that go into calculating a break fee: the remaining term of the loan, the balance outstanding, the bank’s funding cost when the loan was written, and the bank’s funding cost when the loan was discharged.

“If we estimate that we've made a loss as a result of the fixed rate being repaid earlier than expected, we calculate an early repayment adjustment (ERA) as our reasonable estimate of our loss in accordance with our usual formula,” said a spokesperson from CBA. 

“This formula takes into account the difference between our wholesale market swap rate for the fixed-interest period on the date the interest rate was fixed and the wholesale market swap rate as at the date of the early repayment for the balance of the fixed-interest period."

Mitigation strategies for break fees

According to Peter Bond, director and principal adviser at Trinity Wealth Services, having to pay some kind of fee is inevitable. Thankfully, there are some mitigation strategies you can apply when it comes to exiting your loan prematurely:
  1. Check out what interest rates have done since you started the loan. If the bank bills swap rate (BBSW) was higher at the time the loan was started than when you wanted to exit the loan, you can expect to have an exit fee upon changing or exiting the loan.
  2. Banks are usually happy to give you a quote for what the penalty would be if you exit the loan early. This gives you a chance to decide whether you’re comfortable with paying that much in fees before deciding to terminate the loan.
  3. If there’s a strong chance that your financial situation or priorities will change over the coming years, then avoid locking in your loan. As with all financial decisions, the product you choose needs to match your needs.
  4. Some borrowers choose to split their loan between fixed and variable portions. The fixed portion should not exceed the certainty of your circumstances.
While fewer people are actually selling their homes and exiting their loans, the low interest rate environment might actually make exiting a loan a wise move.

This is because if funding rates on fixed rates were to rise, then a mortgage discharge would allow the bank to replace that loan at a higher rate and make a profit. If that is the case, then the client would receive a benefit in exiting the loan.