To Break or not to Break... Hamlet and Mortgages!

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To Break or not to Break, that is the question…whether tis nobler in the mind to suffer the financial slings and arrows of outrageous break costs, and take arms with lower fixed interest rates, and by paying them….save them?

If you had to study Hamlet during college, you would have had the “To Be or Not to Be” thing drilled into you like I did! So the above section is my mortgage broker take on it!

Anyway…..

We are at a critical time in the interest rate cycle. Fixed mortgage interest rates have stabilised over the last few weeks, and some banks have been adjusting their rates by slightly increasing their shorter term rates of 1-2 years but reducing their 3—5 year fixed interest rates. 

If we consider our attitudes towards fixed interest rates from 18 months ago, at the time we all thought that these were very good value at around 5.5-5.75%.

Since then, as we know, interest rates for the same fixed terms dropped to the low 4%’s.

A lot of borrowers that I have talked to in Tauranga, do have fixed interest rates around 5.5% p.a which are not going to be coming off their fixed rate for another year or so. They face the risk of higher fixed interest rates when they come off their current terms.

So the decision they need to make is, should they break their fixed rate term now and re-fix their mortgage for longer at a lower borrowing cost OR keep the current rate and risk a higher rate when the term matures.

To help figure this out, I thought I’d give you some ideas about how to make that decision easier.

The following can be used, as a rough calculation, in case you can’t get hold of your bank for an actual quote on the break fee.

Now, when you break a fixed rate term loan, you will be charged a break fee, if the current mortgage interest rates are lower compared to the rate you are on.

The cost of the break fee will be calculated based on the difference between the “swap rates” at the time you fixed your rate initially, and the swap rate today for the remaining term that the bank can lend the money out for.

Remember the bank has borrowed that money to lend to you for your mortgage initially, and not charging a break fee will see the bank lose money. We can’t have that now, can we?

A little scenario...

Let's say that you fixed your rate on your $250,000 mortgage, in January 2014 for 3 years at 5.9% p.a. This costs you $14,750 per year in interest. You have had that fixed rate for 2 years and you have 1 year left to go.

To calculate the break fee, go to this site, and find out what the 3 year swap rate was 2 years ago, and what the 1 year swap rate is today. 

In this case the 3 year swap 2 years ago was 4.15%, and the 1 year swap today is 2.68%

The cost to the bank of letting you out of your fixed term is the difference between the two swap rates multiplied by your loan amount. 

4.15%-2.68%=1.47%

1.47% x $250,000 = $3675 - That’s your break fee for 1 year.

(If you have longer to go on your fixed rate term, then lets discuss together as the calculation can be a bit more involved.)

So, in this scenario, that’s a fair amount of money right? Now we need to understand what the payoff would be for PAYING this break fee.

Lets say that you now want to fix your home loan rate for 1 year at 4.3% p.a. This rate will see your interest costs at $10,750 for the year. In the first year the difference in interest costs is:

$14750 - $10,750 = $4,000

So although you would pay a break fee of $3,675 for 1 year, you will save $4,000 in interest. So after a year, the break fee has paid for itself, and saved an additional $325. That’s feeding the family for a week or two!

To reduce the cost even further, seeing you are going to be paying a break fee anyway, why not switch banks?

The new bank could give you about $3,000 to switch your mortgage to them.

There will be switching costs involved such as conveyancing / legal fees  and discharge fee, and possibly a requirement for a registered valuation on your property. So all up allow $2,000 for those costs.

You will still be up $1,325.

While you are at it, if you get a registered valuation, you may discover your house has increased in value, and so it’s a great time to talk to me about potentially purchasing an investment property!

How cool would that be!