One of the biggest reforms in the home loan market in recent years was the banning of "early exit fees" on variable rate mortgages. Up until last year, many lenders imposed conditions on their variable rate home loans that meant you paid a penalty fee if you wanted to repay the loan in full or switch within a certain time frame – say three years. In effect, this meant some variable rate home loans combined the "worst of both worlds" – they offered no certainty on rates and therefore repayments, but had a "fixed term" element where you faced a penalty to exit.
That's now changed – new variable rate loans since July 1, 2011 cannot charge an exit fee (though they can charge legitimate administrative costs, generally of a few hundred dollars). But borrowers shouldn't forget that fixed rate home loans continue to charge large fees if you want to exit early. Understanding how these fees are calculated is important – because if you want to take advantage of falling variable rates, you need to be aware of the costs you'll pay and compare them to the savings from a lower rate before taking the plunge.
Most fixed rate home loans charge a "break fee" if you want to exit the loan before the end of the fixed term. So for example, if you took out a three-year fixed loan, and tried to pay it out at the end of year two (because you sold the house, or because you found a much better rate elsewhere, for example), you would generally have to pay a fee for "breaking" the loan early.
The reason break fees are charged is pretty simple. From a lender's point of view, when they lend you money for a three-year fixed term, they are basically doing a deal that you will repay that loan at the end of three years. If you repay it earlier, they then have to re-lend that money to a new borrower in order to keep their business growing. If interest rates are higher when you repay, then the lender wins – but of course, most people wouldn't repay early if prevailing rates were higher. You will generally only repay early if the alternative interest rate is lower – so the lender will then have to "re-lend" that money out at a lower rate than you were paying. From their perspective, that represents a loss of income, and so they will penalise you for that loss via a break fee.
The size of a break fee depends on three factors:
- The amount you have borrowed and outstanding (the more you owe, generally the higher the break fee).
- How long is left on your fixed term (the longer there is to go, generally the higher the break fee).
- The rate you are paying compared to the prevailing rate that the lender is offering now (the lower the prevailing rate compared to your fixed rate, generally the higher the break fee)
As you can see, break fees are never "standard". You'll need to get a quote from your lender to get the exact size of the break fee you'd face. But we can estimate it. Imagine if you owe $300,000 with two years left on the fixed term. Assume that the difference in interest between your fixed rate and the prevailing rate is 1 percent. Our estimate is that a lender would probably charge you a break fee of $6000.
Many borrowers who took out fixed rates in 2007 and early 2008 were hurt by this very equation. As variable rates rose for several years, some borrowers took the certainty of a fixed rate – and might have paid as much as 9.4 percent for a three-year fixed rate. By early 2009, variable rates were as low as 5.15 percent. On a $400,000 home loan, the difference between those two rates would translate to as much as an $1100 per month difference in repayments. Naturally, those borrowers who took out high fixed-rate loans would have been desperate to switch – but the break fees they’d have faced would have been enormous.
If you're unhappy with the rate you’re paying on a fixed rate loan, by all means look at the market – but factor in the break fee before making any decisions. And before you take out a fixed rate loan, remember that break fees will always be there, and make it harder to get out if variable rates fall.