Breaking a fixed-term mortgage to take advantage of lower interest rates could leave homeowners thousands of dollars worse off, experts have warned.
The major banks have started to drop their mortgage rates in anticipation of a cut to the Official Cash Rate by the Reserve Bank, possibly as early as next week.
The downward shift in interest rates will bring relief to many mortgage-holders who are struggling to service their debt.
However, the temptation to switch rates before their fixed term is up could end up costing them dearly, mortgage brokers told OneRoof.
Start your property search
Break fees, or pre-payment fees as banks call them, cover the cost of customers breaking or exiting their loan before the contracted date.
Squirrel founder John Bolton said he was warning homeowners as early as January last year not to fix for long periods because he could foresee the looming scenario that homeowners face now.
He has calculated the cost of breaking early. For a borrower on a $600,000 mortgage who wanted to break three years early, the break fee could be as high as $50,000. “That is a very scary number,” he said. Those with short-term fixed rates might pay around $1500 to $3000.
Discover more:
- Tony Alexander: Markets are betting on steep cuts - so how fast will rates tumble?
- Auckland home in posh suburb has $49,000 asking price - 'this is not a misprint!'
- Revealed: Where Kiwis have the best chance of buying a house for less than $500,000
There were generally no break fees when mortgage rates were rising, said Canstar’s Bruce Pitchers, “because a lender is going to be quite happy to sell you a more expensive mortgage”.
When rates fall, however, it’s a different story. “A lender is going to ensure they recoup all the costs they incur when you switch to a loan with a cheaper rate,” he said, adding that the steeper the rate fall, the higher the break fee.
He gave as an example a homeowner who, 12 months ago, fixed for three years at 7% on money borrowed by the bank at a wholesale funding rate of 5%. If the homeowner wanted to break the loan term with two years still to run on a $500,000 loan, the bank would want to recoup 0.5% of $500,000, which amounts to $5000 over two years.
“To make the deal worthwhile, the homeowner would need to secure a rate that would save them at least the cost of their break fee, $5000, over their next fixed term. And, of course, they will have to factor in the added costs of refinancing, if they are moving to another lender,” he said.
Mortgage adviser Geoff Bawden said borrowers often didn’t think about the consequences of breaking. “People see it as an entitlement, but in fact, it’s a contract. I agree to borrow X amount of money at a certain rate for a certain period. Halfway through that cycle, I can’t go, ‘I don't think I made a good decision. I want you to let me out of it’. There are consequences.”
Bawden said break fees would come as a huge surprise to many mortgage holders. “We’re talking about a whole new generation of borrowers between 2008 and 2024. A lot of the borrowers that are going through it now were still at school in 2008.
“[Younger borrowers] have never experienced the nines and the tens and the higher rates that the rest of us a bit longer in the tooth had all been through.”
Typically, mortgage advisers recommend splitting a mortgage into two or three portions to spread the risk. When homeowners do that, the need to break is less pressing. However, there are many Kiwis who have fixed their entire mortgage on a rate well above what is currently on offer.
Squirrel founder John Bolton has been warning homeowners not to fix for long periods. Photo / Supplied
Bawden said refixing for long periods did not make sense in the current interest rate environment. “We are at the start of what looks like to be a softening cycle. The big decision that you’ve got now is not whether you break early. Why would you break early for a few months and pay break fees when you don’t know what rates are going to be in a few months? Is that a common-sense decision to make? You have to do those sums.”
In the past, banks have offered to pay a customer’s break fees to get their loan. So far that doesn’t appear to be happening in this cycle. “What people might do is look to break their fixed rate and refinance with another bank using the cash that banks are offering for new borrowers to partially meet the cost of break fees,” Bawden said.
Campbell Hastie, of Hastie Mortgages, remembers when mortgage rates dropped off a cliff in 2008 and homeowners screamed blue murder over the break fees banks were charging. Two-year mortgage interest rates fell from 9.62% in April 2008 to 5.93% in February 2009. Some homeowners had fixed for more than five years.
“There were some horrendous stories about the size of break fees following the GFC. If I remember correctly, rates fell something like 300 points in about nine months and I can recall clients getting quoted a $30,000 break fee back then.”
Hastie said cashback offers were a clever way for banks to counter any negative break fee news. “These days banks are using cashback as a retention tool for existing customers, and I think they’ll continue to use that rather than paying break fees per se.
“Cashback is quite clever because it has an element of fairness. Bigger loans get bigger cashback; it can be quite the carrot.
“I think the banks will consider using cashback to assist customers with their break fees instead of risking having a new lender pay cash to do it instead.”
- Click here to find properties for sale
