The reality of breaking a fixed-term loan
Mortgage rates are falling. Here’s what to think about if you’re worried you’re missing out, writes Katrina Shanks.
One of the impacts of Covid-19 has been the plunge in mortgage interest rates, a result of the Reserve Bank moving to ease pressure on households, boost spending, and keep the property market afloat.
Before Covid-19 hit, one of the best rates was 3.38 per cent for one year fixed, but rates have been dropping since March, when the Reserve Bank dropped the Official Cash Rate (OCR) to a record low
0.25 per cent, and said it expected it to remain there for at least
12 months.
In August, one-year fixed-term home loan rates dropped under
2.5 per cent for the first time, and that’s where they’re mostly sitting now. That’s great for someone borrowing money for a mortgage.
But wait, there’s more. Economists are predicting the OCR could go into negative territory next April, perhaps as low as -0.5 per cent.
What does that mean for borrowers?
Well, rates won’t go below zero, but it does mean they could drop below 2 per cent.
That would make buying a house a little more attractive than it is now, ignoring the fact prices are continuing to rise in many areas. But if you already own a house and have a mortgage you fixed before Covid-19, and you’ve been watching rates plummet and are thinking you’re paying way too much, what can you do?
A common reaction is to look at breaking your mortgage to get one of the lower rates. So how easy is that and is it the answer?
It’s quite easy. Banks will allow you to break a fixed term, but it will cost you.
How much depends on how much time is left on the term.
It’s helpful to understand what happens when you take out a fixed loan and what’s behind breaking a mortgage.
When you settle on the amount and fixed-rate term you want, your bank funds that same amount for that same time from the market. If you break your mortgage before the term is up, the bank has to break its commitment to the market, and it pays a fee for that.
The break fee isn’t really a fee, it’s a recovery of the bank’s costs. It’s calculated as the difference between your old rate and the current lower rate that would apply to your remaining fixed term, multiplied by your loan balance and the remaining fixed term.
That’s the simplistic explanation. The actual calculation uses bank funding rates, so occasionally there can be a genuine customer benefit to breaking when bank rates have dropped by less than the drop in customer rates.
So, is breaking a fixed term mortgage the answer?
It depends. This is because the break fee tends to cancel out the benefits of the lower rates, particularly because most people want to break when they have a lot of time left on the term. The longer the term left on your mortgage when you want to break it, the bigger the fee.
Basically, it’s a balancing act, but the most likely outcome from breaking a fixed mortgage would be that it is cost-neutral.
Financial advisers have received many inquiries recently around the benefits of breaking, and most of the time they conclude it’s not worthwhile. One estimate suggests less than 10 per cent of people who inquire actually go through with it.
You may ask yourself, if it’s cost-neutral why would I want to use all that time and energy?
But rather than breaking a fixed term, perhaps a better starting point to getting your mortgages and finances in better shape is to check if you’ve got your mortgage structure right.
Check to see what other options are open.
Have you got savings you could offset against your mortgage to reduce repayments? Some banks offer this off-setting facility.
Or consumer finance debt – such as a car loan – that you could roll into your mortgage to take advantage of its lower interest rates? Often, banks will let you do that, provided you pay the consumer part of the loan back over its original term, so you reduce your repayments but don’t add to your debt.
Or even splitting your one mortgage into more so renewal dates are staggered, allowing you to take advantage of lower rates at different times. Obviously, the reverse applies as rates increase.
Or maybe look at refinancing with another bank to get lower rates and get the cashbacks most offer to get your business.
I know of one case where the break fee was $6000, the cashback from the new bank was $4000, and the interest saving over the term of the loan was $6000 – meaning they were $4000 better off.
Right now, switching banks is a bit harder because the mortgage market is less competitive than before Covid-19, so maybe the best bet is to sit and hope rates stay low for longer until your fixed term expires.
As always, the best advice is to take advice, and independent mortgage advisers will do the calculations for you so you can decide what’s right for you. There has never been a better time to take control of your financial health, wealth, and wellbeing.
There has never been a better time to take control of your financial health, wealth, and wellbeing.