What are break costs?

Locking in your home loan interest rate can sound like an appealing idea. After all, your rate and repayments will stay the same throughout the whole length of the home loan term, even if market interest rates climb higher.

What happens, though, if you decide to switch to a variable rate, pay out the loan early, or refinance to a new loan before your current home loan term has ended?

This is where break fees, also known as break costs, can arise. If you’re looking to break out of your existing home loan contract and switch to a new one, then you could find yourself up for an unexpected expense, potentially running into the thousands.

Here, we take a look at how break costs work, how they are calculated, and consider some questions you may ask yourself if you’re considering switching and breaking out of your current fixed-rate home loan before the term expires.

How to break a fixed-rate home loan

It’s possible to break a fixed-rate home loan contract before the end of the determined timeframe, but doing so is likely to incur fees. Breaking a contract could mean refinancing the home loan or paying it off early. Whichever option you go for, you will typically find your bank or lender charging fees, including break and discharge fees.

These fees could be named differently depending on your lender, so it’s a good idea to read your Product Disclosure Statement (PDS), or contact your lender directly to find out more about what fees may be involved in breaking the contract.

What are break costs?

Break costs, also known as break fees, are charges that some lenders apply when you break out of a fixed-rate home loan before the fixed term of the contract is complete. These kinds of fees are designed to compensate the financial institution for any loss of profit it faces as a result of a customer breaking the terms of the contract, including administration and its own wholesale borrowing costs. It does not typically apply to other types of loans, such as variable-rate loans.

It’s worth noting that ‘break fees’ are different to ‘exit fees’, which only apply to some loans that were signed before 1 July, 2011, which is when they were banned by law. These fees may also be called early termination, deferred establishment or early discharge fees.

When could break fees apply?

According to the Australian financial institution Bankwest, there are a number of situations in which fees could potentially apply when breaking a fixed-rate home loan. They say that you may need to pay break fees if you:

• Switch or split your home loan, meaning that you switch to a variable rate or a different fixed rate, or if you choose to split your current fixed rate into a fixed and variable component

• Increase or ‘top up’ your home loan, meaning you add extra funds and decide to increase the limit of your fixed-rate loan

• Pay off some of your loan early, or choose to pay above your allowed yearly maximum repayment, which some banks and lenders allow for

• Pay off your entire home loan early, which you may do if you choose to sell your home in the midst of your fixed rate period, and use the sale proceeds to repay the loan in full.

How much do home loan break fees cost?

There is no set cost when it comes to breaking a fixed-rate home loan, as fees will be determined on an individual basis by the bank or lender, and will be influenced by a number of factors. Generally, there are three things that go into determining home loan break costs:

1. The interest rate you locked into, compared to the current market interest rate
2. The length of time remaining on your home loan
3. The loan amount you initially borrowed.

The Australian Government’s Moneysmart website suggests that as a general rule, “the more interest rates have come down since you took on the fixed-rate loan, the higher the break fee will be.”

How are home loan break fees calculated?

One of the main determining factors in how break fees are calculated is the Bank Bill Swap Rate (BBSR). The BBSR is the rate at which your lender borrows money from the wholesale money market to fund your loan, and when you take out a fixed-rate loan, your lender pays interest at a fixed rate.

If the BBSR falls between the time that you took out your fixed-rate home loan and the time you want to break out, then your bank or lender will incur a cost, and will pass this cost on to you, in the form of break costs or break fees.

Each bank and lender may do this calculation differently, but one formula used by Australian lenders is: the difference between the BBSR when your loan was taken out and when it ends multiplied by the amount of time left on the loan and the current principle.

To put this in context, consider this hypothetical example: say that you have two years left on your fixed-rate home loan, and the current principal of your loan is $400,000. When you took the loan out, the wholesale money market rate was 4.00% p.a. and now it is 3.50% p.a.

(4.00% p.a. – 3.50% p.a.) x 2 x $400,000 = $4,000 break fee 

Of course, in this calculation, interest rates have fallen between the time the loan was taken out and the time that it came to an end. If interest rates had risen in that period, then it might work out in your bank or lender’s favour if you broke out early.

Home Loan Experts, an Australian mortgage broker, advise that, in a situation where rates have risen, it’s important to ask your bank or lender exactly how they calculate their break fees if you plan to break out of a loan early, to ensure you are getting a fair deal.

If in doubt, ask your bank or lender to be as transparent as possible when explaining how they calculate your break fees or costs.

Is it worth breaking a fixed-rate home loan to get a cheaper rate?

If you’re on a fixed-rate home loan and you see a cheaper rate out there that you want to switch to, you may be able to do this by breaking out of your existing loan, but it’s worth first asking if the fees and charges you pay might outweigh the benefits.

Even if you do find a cheaper home loan rate with a different provider (or even a cheaper rate that you wish to refinance to with your existing provider), it’s important to determine whether the cost of break fees will cancel out the savings you will make over the lifetime of the new loan.

What other fees do you pay when breaking a home loan?

The fees you pay when breaking out of a fixed-rate home loan will depend on your individual bank or lender, however, you may find that in addition to break fees, you are charged administration fees. These are fees that are intended to cover the costs of processing and administration when you change your home loan, and they will be outlined in your contract. You can also ask your bank or lender how much they might charge you in administration fees for breaking your fixed-rate home loan early.

Can you avoid break fees for fixed-rate home loans?

Generally speaking, if you are planning on breaking a fixed-rate home loan contract, you will be required to pay break costs. The only guaranteed way to avoid this could be to see out the remainder of the term before switching.

If you’re in the market for a home loan, it could be wise to ask your financial institution what break fees are associated with its home loan products, and to take this into consideration when choosing your loan.

It may also pay to compare a different type of loan, which, for example, may have a slightly higher interest rate but lower break fees, to see if that option would work out cheaper if you decide to repay it early.

How can you compare fixed-rate home loans?

If you’re looking for a cheaper fixed rate than your current one, you can start by comparing home loans on Canstar’s database to understand the rates available, including the features you want (perhaps an offset account or redraw facility), and running your own calculations of how much difference there will be in repayments between your current loan and the ones you are considering.

You can then weigh this up against the break fees you’d be charged for leaving your current fixed-rate home loan, to work out what the potential savings might be. You will also need to take into consideration such things as discharge fees, application fees (with the new lender) and whether you will be required to pay stamp duty when refinancing. There may, however, be deals and offers associated with refinancing, usually in the form of a cashback.

It’s also a good idea to consider the length of the term, as switching to a new loan with a better rate but extending the length of the loan could cost you more over the lifetime of the loan. You can also contact your current lender to see if you can negotiate a better deal on your home loan. If you switch loans with the same provider, you may have to pay a switching fee.

If you’re considering a switch, it’s often worth reading a lender’s documentation, such as the Product Disclosure Statement (PDS) and Target Market Determination (TMD), for any loan you are considering.

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