What Is A Break Cost And How To Avoid It While Getting A Home Loan

Are you wondering whether you could be getting a better deal on your fixed-rate home loan? Well, you’re not alone with refinancing on home loans reaching an all-time high.

Along with our ultimate guide for Australian citizens living abroad, we want to make sure you know all the terms written into your current or future fixed-rate mortgage.

A fixed-rate loan can ensure extra stability for homeowners. However, they’re also quite rigid and don’t leave much room for change, unless you’re prepared to pay extra costs.

The extra cost you need to know about when considering any changes to your home loan is the “break cost”. In this article, we’ll clear up its definition, how it’s calculated, and let you know whether you can avoid paying these extra costs.

What Is A Break Cost?

A break cost is a fee charged by the lender (bank) to the borrower (you) if the borrower breaks the fixed-rate period on their home loan before its completion. This occurs when borrowers decide to switch or refinance their fixed-rate mortgage.

Break costs are also charged to the borrower if they begin to make repayments above the maximum amount set by the lender.

Generally, break costs only apply to fixed-rate loans and it’s rare to find them attached to variable-rate loans or any other types of loans.

As fixed-rate loans allow borrowers to pay off a set amount of their home loan each year without being charged, going over this amount is considered by the bank as “breaking” the initial terms.

While paying off your mortgage as early as possible may seem like the best thing to do, keep in mind that a break fee may have you paying a significant amount of money to your lender.

Why Do Lenders Charge Break Costs?

Break costs are put in place so a lender can be compensated for any loss of profit they face due to the borrower breaking the terms of a fixed-rate loan.

When a fixed interest rate and time period is agreed upon between you and the lender, the lender then obtains money from the market at a wholesale interest rate. This is a rate that correlates to your ability to make the repayments within the allocated fixed-rate period.

Wholesale interest rates may change in the time period of your loan, so when borrowers break the terms lenders can experience losses.

In summary, break costs act as a security blanket for lenders against any future changes in interest to the fixed-rate loan.

If you’re concerned about how break costs may affect your specific fixed-rate home loan then trusted mortgage brokers like Odin Mortgage can calculate everything for you, and show you ways to lower your interest rate.

When Do Break Costs Apply?

Break costs will typically apply when one of the following four actions are carried out by the borrower.

Making Extra Repayments

If you make any more additional payments in addition to your regular set repayments via a lump sum or spread across a period of time, you may be charged break fees.

Depending on the lender, you may be allowed to make extra repayments in your fixed-rate period. However, there will be a limit to how much.

Refinancing

Break fees are also likely to be charged when you want to switch to another loan before the fixed-rate period is over.

Many people choose to refinance for a number of reasons, including lowering their interest rate, changing to a variable-rate loan, or looking to make extra repayments.

Before making the decision to refinance, it’s crucial to know whether it’s worth incurring the break fees. This will depend on your financial situation, but it’s useful to seek out a good mortgage broker like those available at Odin Mortgage to assess the decision before making it.

Selling Property

When selling your property within a fixed-rate period, you may have to pay break costs if the loan is not transferable. This is usually referred to as loan portability which allows you to transfer loans between properties.

If your home loan is portable then you can avoid paying break costs.

Paying Off The Entire Loan Before The End Of The Fixed-Rate Period

Break costs will be incurred if you want to pay off your fixed-rate loan in its entirety before the end of the fixed time period. When paying off your home loan early, the break cost is designed to be high to cover the lender from any losses they may face.

How Are Break Costs Calculated?

A break cost is calculated by working out the difference between the wholesale interest rate at the time of the loan’s establishment and the rate when you have decided to break the loan. This is known as the Interest Rate Differential.

This difference is then calculated up with the remaining fixed-rate term of the loan and the total loan amount.

Each bank formula may differ, but it functions as an estimate of the interest they would have received if the fixed-rate period was not broken.

Generally, a break cost formula will look like this:

Break cost = Change In Cost of Funds (Interest Rate Differential) x Remaining Fixed-Term x Total Loan Amount.

Example Of Break Cost Calculation

Let’s take a look at an example of a borrower who takes out a fixed-rate loan of $400,000 with a fixed interest rate of 4.00% p.a. (per annum) for 5 years but repays it in 3 years. This is the process a bank may take to calculate the borrower’s break cost.

The 5-year wholesale interest rate on the loan was fixed at 4.00% p.a but the rates have changed since then.
After paying it off in 3 years, the current fixed wholesale interest rate is at 3.00% p.a.
The Interest Rate Differential between these two is 1.00% p.a.
With 2 years left to pay and an interest differential of 1.00%, the break cost formula will look like this:
Break cost fee = $400,000 x 1.00% x 2 years
Break cost fee = $8,000

How Can I Avoid Paying Break Costs?

While most fixed-rate loans incur break cost fees upon a change to the terms of the original agreement, there are a few ways you can get around paying these charges.

Loan Portability When Moving Properties

As we mentioned early, loan portability refers to a loan that can be transferred between properties when you decide to move.

When taking out a fixed-rate loan, check whether it includes a feature that allows the borrower to transfer an existing loan onto a new property.

Also, loan portability allows the borrower to avoid paying establishment fees which is a one-off payment to cover the documentation of a new mortgage.

Split Loans

For a perfect combination of stability and flexibility when it comes to changes in your mortgage, consider looking into split-rate home loans. Split loans are a type of home loan that gives you the benefit of both fixed-rate and variable-rate loans.

Another advantage of split loans is that they usually have no limit to the number of extra repayments you can make. Therefore, you can avoid repayment break costs, and add other features like an offset account.

Variable Rates

Finally, the most common means of avoiding break costs is to plan ahead with a variable interest rate loan. If you’re likely to change your loan in the near future or refinance, consider avoiding fixed-rate loans.

The fixed-rate period generally lasts between 1-5 years, whereas a variable-rate loan allows you to refinance at any time without suffering from break costs.

Got Any More Questions About Break Costs?

Now you know that choosing the right loan type will allow you to avoid future break cost fees and make unlimited additional repayments, why not meet with an experienced broker to find that perfect flexible loan for you?

Start your free online assessment today, and we at Odin Mortgage can find flexible options on fixed and variable-rate loans to provide you with peace of mind about future break cost fees.

As the #1 Australian Expat Mortgage Brokers, we’re ready on a day and time that suits you.

Frequently Asked Questions

What Are Break Fees?

Breaks fees or “break costs” refer to a fee incurred on a fixed-rate home loan that is charged to the borrower if any changes occur during the fixed-rate period on the contract. It is a means of the bank avoiding any potential losses they may experience on the home loan. Break fees can be applied when refinancing, making additional repayments, and selling a property.

How Do You Avoid Break Costs On A Fixed Loan?

There are two ways you can avoid break cost fees on a fixed loan. Firstly, having home loan portability will let you transfer a loan between properties without incurring any break costs fees. Secondly, a split-rate loan which is both fixed and variable will allow you to make extra repayments without having to pay break costs.

How Much Will It Cost To Break My Mortgage?

Break costs are usually calculated by your lender using a set formula. It’s calculated by working out the difference in the interest between the start of your loan and the time decided to break the loan (Interest Rate Differential). This difference is then multiplied by the remaining time period and the loan amount.

What Is The Penalty For Breaking A Mortgage Early?

The penalty for breaking a mortgage early is known as the “break cost” or “break fee”. This amount is calculated by working out how much the borrower still owes depending on a change in the interest rates. Break fees are put in place so a bank can be compensated for any loss of profit they face due to the borrower breaking the terms of a fixed-rate loan.