A break cost is a penalty that is payable by customers who close down a fixed-rate home loan before its expiry. It’s important to recognise that this break cost is only payable on fixed interest rate loans and not variable, therefore it’s important to consider how you structure your finances. Break costs or exit penalties have not been charged on variable rate loans since 1 July 2011, but it’s still important to review your agreements with your lender.
This week we explore what you need to know about break costs and how they can impact your finances.
Firstly, let’s outline why break costs are payable
When you take out a fixed rate loan from your lender, they use what’s called a Bank Bill Swap Rate (BBSR) to borrow the funds from the wholesale market to provide your loan. This BBSR does not allow for early repayment without penalty, which is why your lender will pass this cost on. The break cost becomes payable if you pay off your fixed rate loan early, or if you make higher repayments than your loan agreement allows for. Most fixed rate loans will allow for additional repayments of a fixed amount above your minimum amount each year, and you’ll face penalties if this amount is exceeded.
It’s important to recognise that these break costs would also be incurred if you decided to refinance your loan to another lender if your current agreement is a fixed loan and it’s not yet expired. The amount of the break cost is typically in the thousands, and is calculated by the lender based on the loan amount, interest rate and the amount of time left in your fixed loan term.
Let’s consider an example
In this example, John and Susanne have purchased a home for $800,000 and borrowed $500,000 as a loan. They decided to fix their interest rates for a 5 year period at a rate of 5%. After 3 years, John is offered a position overseas in Hong Kong and they decide to sell their property to cover some of the moving costs, and therefore repay the loan following the sale of the property. At the point of the sale of their property, interest rates on the fixed rate loans have dropped to 4%, a 1% decrease from the interest rate on their loan.
John and Susanne, therefore face break costs, which are calculated as follows:
$500,000 x 2 years x 1% = $10,000
Break costs can often go by different names
Different lenders will often use differing terminology for break costs, so it’s important to ask your mortgage broker or lender what they call it, and any other costs involved. Other terms that can be used for break costs include; early repayment fees, early repayment adjustments, prepayment fees, fixed rate early termination fees and economic costs.
What do you need to consider
When interest rates are at record lows, like they have been for the past 18 – 24 months in Australia, it can be a worthwhile consideration to fix your interest rates on your home or investment property loan. There are a number of key considerations that you should review, the first of which is whether you may wish to sell your property in the short to medium term. For example, if there is a chance that you may wish to sell your property within 3 years, then it wouldn’t be sensible to consider a fixed term loan of 5 years or longer.
Secondly, you should consider whether you may wish to access equity in your property in the short term to expand your property portfolio or renovate your existing properties. If you do, then it’s important to consider whether your current lender will provide you with such a facility or if you would need to refinance at the time. You need to consider the term of your fixed rate loan if you are planning on exploring such strategies.
Finally, discuss with your mortgage broker or financial planner where you see future interest rates heading relative to the rate cycle. Are we currently at the trough in the market? Are interest rates likely to rise in the short term? Are rates likely to be cheaper in the medium term and are we therefore best to explore shorter-term fixed rate loans, or keep them variable for a period of time.
Explore your strategies with your mortgage broker
As always, it’s important to discuss your financial plans with your mortgage broker and financial planner, and ensure that your loans are structured appropriately.
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