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Exiting a loan can still be extremely costly

Wednesday, 4th Sep 2013
Categories: Finance, Newsletter

doing sums

You’re probably aware of the fact that since the first of July 2011, lenders cannot charge “early exit fees” on variable rate home loans. But what some borrowers have forgotten is that the legislation doesn’t apply to fixed rate loans, which are growing in popularity due to the extremely low interest rates being offered.

Taking out a fixed rate loan can be a relatively easy process and deliver significant benefits to certain borrowers. However, breaking such a loan can still be very expensive.

How do you ‘break’ a loan?

There are a few scenarios that could trigger the hefty break costs associated with fixed rate loans. Repaying the loan before the end of the fixed rate period or switching to a different product within this time are the more obvious ones.

But even just making extra repayments on a fixed rate loan can cause some lenders to charge you penalties. While most lenders will allow you to pay a small amount off your loan each year without being charged, going above the accepted tolerance could prove costly.

Why are lenders allowed to charge for this?

A fixed rate loan is a legal contract guaranteeing that you’ll pay a fixed amount of interest on a loan for a certain period of time. Breaking this contract means your lender is entitled to be compensated for any losses incurred.

How much will you pay?

Calculating the costs involved with breaking a fixed rate loan can be quite complex. A key factor is how the interest rate on the fixed loan compares to current interest rates being offered. If interest rates are currently lower that the rate on your fixed rate loan, then the costs could be significant as the lender won’t be able to make as much money from re-lending the money.

On the other hand, if interest rates are higher, then there may be no costs involved with breaking the fixed rate loan. But borrowers don’t often exit a loan if they are paying lower than the prevailing rate.

The amount owing on the loan will also impact on the calculation of break costs, generally the more owed the higher the costs. Similarly, more time there is left in the fixed term of the loan the bigger the costs. Breaking a 10-year fixed rate loan therefore could be extremely expensive, which is why most borrowers typically choose terms of 2-5 years.

Here’s what to do

If you currently have a fixed rate loan and need to break it, before you do anything ask your finance broker to obtain a quote from the relevant lender regarding all break costs. From there you can make an informed decision about whether the benefits outweigh the costs.

If you are considering choosing a fixed rate loan for a new purchase or to refinance, think sensibly about the flexibility you’ll need in future and the potential costs you could face by locking in a fixed interest rate. Again, your finance broker will prove invaluable in helping you to make this important assessment.