Fixing your home loan can sometimes prove a millstone
While it might give you peace of mind knowing exactly how much money you will be paying month in and month out till the end of the loan term, you can end up paying seriously over the odds if rates are falling.
Those who choose to fix their interest rates are betting on either the interest rates going up or remaining steady (where the available fixed rate is lower than the available variable rate). If there are significant falls in variable rates the fixed rate may become a millstone as you watch standard rates soften.
Break costs
If are thinking about switching into a variable or other loan, it’s important to recognise the break costs associated with getting out of a fixed loan in a falling interest rate market.
The banks call this break cost an "economic cost".
To understand why an economic cost arises, you need to understand that in order to lend money to you at a fixed rate for a particular period, the bank borrows funds from someone else (e.g. other banks, small businesses, personal depositors) for the same period. The interest rate at which your bank borrows from the market to fund your loan is called the ‘cost of funds rate’.
Just as you have an obligation to repay your loan, your bank has an obligation to repay those funds at the rate and on the conditions they agreed when they sourced them on your behalf. The bank may seek to recover the economic cost associated with the fixed rate loan.
How is the economic cost calculated?
Economic cost is based on the:
- amount of money borrowed.
- remaining period at the fixed rate.
- contracted loan repayments.
- cost of funds at the start of the fixed rate term of your loan.
- cost of funds at the time you repay the loan.
Fixed rate
Breaking a home loan during a fixed interest period can be expensive, which is why it's always worth having a word with your broker before breaking a fixed interest home loan.
Stuck with a fixed rate?
A fixed home loan is a legal contract guaranteeing that you'll repay a fixed amount of interest on a loan for a specified time period. If you decide to break that contract by switching banks/rates, your existing lender must be compensated for any loss they incur.
Considering breaking a fixed rate loan? Contact us for assistance.