#57 Borrow Smart Series – Breaking a Fixed Rate Loan: What Are the Costs

Breaking a Fixed Rate Loan: Understanding the Costs and Considerations.

Fixed rate home loans offer borrowers the security of knowing exactly what their repayments will be for a set period. However, circumstances can change, and you might find yourself needing or wanting to break your fixed rate loan before the term ends. It’s crucial to understand that doing so can come with significant costs. Let’s delve into the key aspects of breaking a fixed rate loan and what you need to consider.

Understanding Break Costs

Break costs, also known as early repayment adjustment (ERA) or economic cost, are fees charged by lenders when a borrower exits a fixed rate loan before the fixed term expires. These costs are designed to compensate the lender for the financial loss they incur when you break the contract.

How Break Costs are Calculated

The calculation of break costs can be complex, but generally, it’s based on:

1. The difference between your fixed interest rate and the current market rate
2. The remaining term of your fixed rate period
3. The loan amount

If interest rates have fallen since you locked in your fixed rate, the break costs can be substantial. Conversely, if rates have risen, the break costs may be minimal or even zero.

Scenarios Where Break Costs Apply

Break costs may be incurred in several situations:

1. Refinancing to another lender
2. Switching to a variable rate loan with the same lender
3. Making substantial extra repayments beyond allowed limits
4. Selling your property and repaying the loan in full

The Impact of Interest Rate Movements

The direction and magnitude of interest rate changes since you fixed your loan play a crucial role in determining break costs:

• Falling Rates: If rates have decreased, break costs can be significant. The lender stands to lose money by releasing you from a higher rate when they can only relend at a lower rate.
• Rising Rates: If rates have increased, break costs may be minimal or non-existent, as the lender can potentially relend the money at a higher rate.

Real-World Example

Let’s consider a scenario:

• You have a $500,000 loan fixed at 4% for 3 years
• After 1 year, you want to break the loan
• Current market rates for the remaining 2 years are at 2.5%

In this case, the break cost could be substantial, potentially tens of thousands of dollars, as the lender is losing 1.5% interest on $500,000 for 2 years.

Alternatives to Breaking Your Fixed Rate Loan

Before deciding to break your fixed rate loan, consider these alternatives:

1. Wait it out: If possible, wait until the fixed term expires to avoid break costs.
2. Partial break: Some lenders allow you to break only a portion of your fixed loan.
3. Loan portability: If you’re selling and buying, check if your loan is portable to the new property.
4. Renting out your property: If you need to move, consider renting out your property until the fixed term ends.

The Importance of Consultation

Always consult with your lender or mortgage broker before making any decisions about breaking your fixed rate loan. They can provide:

• Detailed break cost calculations based on your specific loan details
• Advice on potential alternatives
• Insights into whether breaking the loan is financially beneficial in the long term

The Role of Your Mortgage Broker

A mortgage broker can be invaluable when considering breaking a fixed rate loan. They can:

1. Request and interpret break cost quotes from your lender
2. Provide a comprehensive cost-benefit analysis
3. Explore alternatives that might better suit your needs
4. If breaking the loan is the best option, help you navigate the process and potentially negotiate with lenders

Conclusion

Breaking a fixed rate loan before the term ends can indeed incur significant costs, especially in a falling interest rate environment. These costs are designed to compensate lenders for their potential losses and are a standard part of fixed rate loan contracts.Before making any decisions about breaking your fixed rate loan:

1. Understand how break costs are calculated and what factors influence them
2. Consider the reasons for wanting to break the loan and explore all alternatives
3. Consult with your lender or mortgage broker to get accurate break cost calculations
4. Weigh the short-term costs against the potential long-term benefits

Remember, while the costs of breaking a fixed rate loan can be high, there may be situations where it’s still financially beneficial in the long run. For example, if you can refinance to a significantly lower rate, the savings over time might outweigh the break costs.

By working closely with your mortgage broker and carefully considering all aspects of your financial situation, you can make an informed decision about whether breaking your fixed rate loan is the right move for you. Your broker can provide the detailed calculations and expert advice needed to navigate this complex financial decision, ensuring you understand all implications and explore all available options.

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