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

When applying for a home loan, choosing a fixed rate or variable rate is a big decision. While each option has its advantages and disadvantages, borrowers that are after security and certainty, especially in the first few years of their home loan, typically opt to get a fixed rate.

A fixed-rate home loan allows borrowers to lock in their interest rate for a certain period of time. This means borrowers are paying the same amount each month for the entire fixed-rate period, which provides some structure and clarity on how long it will take you to pay off your home loan and how much it will cost.

What is a fixed-rate contract?

When you choose a fixed interest rate , it is not a quick request you put in writing - you need to enter a fixed-rate home loan contract that is legally binding. A fixed-rate deal means you’ll be repaying a fixed amount of interest on your mortgage for a specified period.

Once the fixed-rate period ends, you can enter another fixed-rate period. However, this doesn’t mean you will be charged the same rate you were before. Instead, your new rate will be subject to the fixed rates currently being offered by your lender.

If you’re currently in a fixed-rate contract, but you want to break out of it, it will be expensive. As well as some paperwork, you will likely need to pay some fees to exit the agreement.

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

Anything that stops you from fulfilling the terms and conditions of the contract would be tantamount to breaking the deal. For instance, if you choose to switch to another lender or home-loan product, that would require you to break your current fixed-rate contract.

Another example would be making extra repayments beyond what is stated in the contract or repaying the loan earlier than expected.

In all of these situations, you would be breaching your fixed-rate contract, leaving you liable to pay certain fees to the lender.

This makes it important for you to understand your loan contract — your mortgage broker will be able to help you get a good sense of what you need to know about your loan.

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

Before entering a fixed-rate contract, make sure to ask your lender what charges might apply to people that ditch their fixed-rate deals. There’s no set standard for break lease fees, so different lenders will likely offer different fees should you decide to terminate your contract.

Borrowers that break their fixed-rate contract will usually need to pay a fee. In essence, a break lease cost is a penalty paid by customers that exit their fixed-rate contracts before the agreed end date. They might not call it a ‘break costs’ or ‘break fees’ - lookout for wording like ‘early exit fees’ and ‘early repayment penalties’. All of these things are essentially costs for exiting the agreement early.

How are break costs calculated?

The break cost calculation involves the Bank Bill Swap Rate (BBSR), which is what lenders use when borrowing money from a wholesale market. It’s the interest rate changed on wholesale fixed-rate borrowing.

When you exit a contract prematurely, you’re essentially disrupting the BBSR balance, which results in the bank incurring a cost. This is the cost that is passed onto you in the form of an exit fee.

While banks use different formulas to calculate 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 to break will be.

Typically, banks determine the break costs by multiplying the loan amount to the remaining fixed term and the change in interest rates.

For 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, 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 = $500,000 * 3 (remaining years) * 0.5% (difference)

The result, $7,500, is the approximate cost to break the contract you would most likely incur. However, this is just an example, and banks don’t follow a standard rule in calculating their break costs. If you’re worried about how much you’ve been charged, ask your lender for a breakdown of how they calculate their fees.

Can you avoid break costs?

There is one way to avoid incurring break costs — finish your fixed-rate contract. Unfortunately, if you want to get out of a fixed-rate contract early, you’re likely going to need to pay the accompanying break costs. So if you really want to avoid paying exit fees, you might not have another choice but to stick with your current agreement and refinance when you roll over to a variable rate.

If there’s a deal on the table and it’s too good to turn down, you should work out what the break cost might be to see if it is still cheaper in the long run. Otherwise, it might end up being more cost-effective to wait the fixed-rate period of your home loan to expire before finding something that suits you.

If you are still unsure, you might want to consider reaching out to a mortgage broker or financial adviser. Speaking to a professional can help you plan for your financial future, and decide whether splitting early ends up being the better option.

This article was last updated on 12 January 2022.

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