So, you’re thinking of refinancing to another lender to take advantage of some attractive interest rates (and refinance rebates) you’ve seen being offered.
The thing is, you have a fixed rate loan. And as a borrower with a fixed rate loan, you already know that your fixed rate loan essentially locks you into an agreed interest rate and specific repayment for a set period of time “the fixed term.” And you also know that if you refinance this fixed rate loan, it’s likely you’ll incur ‘break costs.’
So what exactly is a break cost?
How are break costs calculated?
And when should you pay break costs (if ever)?
What is a break cost?
A break cost (which can also be called an ‘Early Repayment Adjustment’, or ‘Early Repayment Cost’ depending on your lender) is a fee passed on to you by your lender when you choose to break or make changes to your fixed rate loan contract.
For example if you refinance your loan, sell your property (which would therefore discharge the loan), switch to a variable rate, or even make repayments above the ‘prepayment threshold,’ during the fixed rate period, your lender can charge you a ‘Break Cost.’
Why does a lender charge break costs on a fixed rate loan?
It’s related to how fixed rate loans are funded by the lender.
When you take out a fixed rate loan, the lender agrees to fix the interest rate on your loan for a specified period of time. The lender sources funds for this loan by borrowing money from wholesale money markets.
The lender has offered you a specific fixed rate based on the cost they incur to source the funds. So when you break your fixed rate term, it’s possible the lender will incur costs to unlock the funding agreement *they* have in place. The lender recovers these costs by charging you a ‘Break Cost.”
How are Break Costs calculated?
Lenders use complex formulas to calculate a Break Cost.
We’ve looked at a few of the Break Cost formulas used by a number of lenders* and whilst they vary, the main factors that come into play include:
- Amount of your loan
- Loan balance at the date of payout (or the date you break the fixed rate loan)
- Period of time between the payout/ break date and the end of the fixed rate period
- The fixed interest rate at which the lender could make another home loan
- Wholesale Market Interest Rates (the rate at which the lender can obtain funds from wholesale money markets) at the date you fixed your loan and the date you wish to exit your loan
- The applicable interest rate margin – this is the difference between the annual percentage rate under your loan agreement and the wholesale market interest rate
Break Costs vary significantly and will heavily depend on what interest rates are doing at the time you wish you break your fixed rate loan.
If interest rates increase, Break Costs are likely to decrease because there’s a good chance the lender can make money from your exit.
If interest rates decrease, Break Costs are likely to increase because the lender is likely to incur losses as a result you breaking your loan term.
To find out what Break Cost you would incur from breaking your own fixed rate loan, you need to get a quote from your lender. Since they’re calculated using wholesale market rates, break costs can vary daily and are generally only valid for a few days.
Should you ever pay Break Costs?
Your decision to break your fixed rate loan and pay Break Costs of course depends on your personal situation.
First, you need to know exactly what the Break Cost will be.
Second, you need to determine whether the benefit of paying the Break Cost is worth it. If you’re refinancing to another lender, how long will it take for you to re-coup the Break Cost? You would need to be obtaining a significant interest saving to make it worthwhile. However, if the interest saving benefits from refinancing are going to be significant, it’s likely you’re locked into a higher fixed rate (which means your Break Cost are also likely to be high).
Third, you need to look at the other factors – like the reason for wanting to sell your property. Is it an urgent sale? Do you have another option? Could you wait a little longer until the fixed term expires, so when the property sells you can retain the proceeds rather than using them to cover Break Costs?
If you need some working out what options you have with regards to your existing fixed rate loans, we’re here to help!
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*We reviewed ‘Break Cost’ formulas for CBA, Westpac, St George, ANZ, Bank of Queensland and Bendigo Bank.
