Thinking of breaking a fixed-rate contract? Here's what you should know

Choosing between a fixed rate or variable rate home loan can be a big call. While each has its advantages and disadvantages, borrowers looking for certainty around their repayments, especially in the first few years of their home loan, may prefer a fixed interest rate.

A fixed-rate home loan allows borrowers to lock in their rate for a set period. It also means they’ll be paying the same amount each month during that time. But if borrowers want to pay extra on their home loans or they see interest rates falling on the wider market, they may consider breaking their fixed-rate contract.

What is a fixed-rate contract?

When you choose a fixed interest rate, you are essentially entering a legal contract agreeing that you will repay a regular amount for a specified period. Once that period ends, you are free to negotiate another fixed-rate contract or, alternatively, switch to a variable rate. This will very likely depend on the interest rates being offered on the market at the time as well as your individual circumstances and preferences.

But if you’re on a fixed-rate contract and want to end the contract before the set period, chances are you’ll be facing what are known as break fees. These are levied if you vary your contract in any way and the cost for doing so can be considerable.

What does 'breaking' a fixed-rate home-loan contract mean?

Anything that sees you deviate from the terms and conditions set down in your home loan contract will likely attract break fees. This can include wanting to pay more than your set repayments or paying your home loan out early.

You'll also be up for break fees if you wish to switch to a different home loan product with the same, or another, lender, or if you sell your property.

Here's some of the lowest owner occupier home loan interest rates currently on the market if you're looking to determine whether breaking your fixed-rate contract may be worth your while:

Important Information and Comparison Rate Warning

What fees do you have to pay when you break a fixed-rate contract?

Before entering into any fixed-rate home loan, it pays to ask your lender what charges might apply to borrowers who break their contracts.

One reason is because there’s no standard way lenders calculate their break fees. Different lenders will apply different methods, and they will be based on the specifics of each fixed rate contract.

But one factor that will typically apply to anyone considering ending a fixed rate period early is a break lease cost. Break lease costs are penalties imposed on all borrowers who break their contract before the agreed end date and they have a few different names, including ‘early exit fee’ or ‘early replacement penalty’. This cost is generally a given, on top of the other fees calculated by your lender.

How are break costs calculated?

This is where things can get a bit complex. Basically, lenders will look to recoup their cost of doing business with you. They will have written your loan based on you paying them a certain amount of money over a set amount time. Your loan would have been based on what rate they had to borrow the money at from the wholesale money market, plus their profit on top.

That’s where so-called Bank Bill Swap Rate (BBSR) comes in. This is a benchmark interest rate lenders pay when borrowing from the wholesale market to finance loans.

When you exit a contract prematurely, you’re essentially disrupting your lender’s BBSR calculations, which can result in them carrying an unexpected cost. This will be the basis of the cost passed onto you.

While lenders all use different formulas to calculate their break costs, it usually involves comparing the original BBSR with the rate at the time you break your contract. The more time you have left on your contract when you break, the higher the cost may be.

Typically, banks determine the break costs by multiplying the loan amount to the remaining fixed term and the change in interest rates, so something like this:

Break cost = Loan amount already paid x (interest rate differential) x remaining contract term

An example

Let’s say you have a $500,000 home loan with a fixed rate of 5.5% p.a. for five years. In the second year of your fixed-rate contract, with a loan balance of $475,000, you decide to refinance, which means you need to break the contract. During this time, your lender’s fixed rate was reduced to 5%. Using this example, the difference between the original BBSR and the current rate is 0.5%.

Break Cost = $475,000 x 3 (remaining years) x 0.5% (difference)

The result, $7,125, is the approximate cost to break the contract. However, this is just an example, and lenders generally don’t follow a standard equation in calculating their break costs.

If you’re concerned about much you’re going to be charged, ask your lender for a breakdown of how they calculate their fees. (However, be warned, some of their equations will be considerably more complex.)

Do you still pay break costs if the BBSR goes up?

This is a good question. There’s nothing to say the BBSR won’t go up in the time you want to break your contract, and your lender will actually stand to make more profit by loaning the money to someone else at a higher rate than what they borrowed it at.

Technically speaking, you might not have to pay excessive break fees, although you’ll probably still be hit with other charges such as exit costs or loan discharge fees.

Can you avoid break costs?

There is only one surefire way to avoid incurring break costs and that is to complete your fixed-rate contract to its end date. If you want to get out of a fixed-rate contract early, you’re likely going to need to pay accompanying break fees and other loan exit costs.

If you really want to avoid paying hefty fees, you may have little choice but to stick with your current agreement and refinance, or renegotiate, when your contract is due to expire.

But, if there’s a better deal on the table and it seems too good to turn down, by all means calculate what the break cost might be and determine whether you’ll end up in front in the long run.

If you’re unsure, it’s wise to consult a mortgage broker or financial adviser to run the figures for you.

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