I often get asked whether it is worthwhile breaking an existing fixed-rate arrangement on a loan. With the current interest rate environment being at an all-time low, I thought I’d address this question with a brief and general guide on how to determine if breaking your fixed rate would be worth the break-cost.
As you may know, when you enter into a fixed-rate loan arrangement, that arrangement is generally for a finite period, e.g. one, two, three, four or five years. Lender’s will often charge you an ‘early-repayment fee’ or ‘break-cost’ for paying lump sums over and above the contracted repayments and/or ending this arrangement before the contracted term is over.
How lenders work this break-cost out is generally by taking the difference between your contracted fixed-rate and the advertised fixed-rate at the time you break the contract, and then apply that to your current loan amount multiplied by the remaining contracted term.
For example, let’s assume the following:
- Loan amount: $1,000,000;
- Contracted Fixed-Rate: 3.99% pa;
- Remaining loan term: 2 years of a 3 year fixed-rate term;
- The currently advertised fixed-rate for 3 years: 2.85% pa.
We can work out an estimated break-cost as follows:
- Firstly, work out the difference between the contracted fixed-rate and the currently advertised fixed-rate: 3.99% – 2.85% = 1.14% pa difference;
- Apply this to the loan amount: $1,000,000 X 1.14% = $11,400 pa in interest that the lender will forgo if the contracted fixed-rate is broken;
- Multiply this interest amount by the remaining term of the fixed rate: $11,400 x 2 years remaining = $22,800 in potential break-costs.*
So, is it worthwhile breaking the fixed rate in the above example? From the above, we can see that if the 3.99% pa 3-year fixed-rate is broken after only one year, and if it was replaced with a 2.85% 3-year fixed-rate, after absorbing the break-cost you would only see a benefit in the third year of the new fixed-rate. This is because the first two years would be spent paying back the break-cost with the benefit of the new reduced rate:
- Break-Cost = $22,800;
- LESS $11,400 benefit in year 1 = $11,400 left of break-cost;
- LESS $11,400 benefit in Year 2 = $0 left of break-cost i.e. Break Even Point has been reached;
- A further $11,400 benefit in Year 3 puts you in front and therefore there may be a benefit to breaking the fixed rate in this example.*
Further to this, if you were able to secure this new rate of 2.85% pa over say a 5-year fixed-rate, then your benefit continues (from Year 3) in years four and five ($11,400 x 3 (years 3, 4 & 5) = $34,200 benefit). This financial benefit is also complemented by the added certainty of an additional two years locked in at the lower rate (if a 5-year fixed rate is taken).
*Working out if absorbing the break cost will be worthwhile depends largely on the interest rate environment now, and over the period your borrowing strategy is set over. There are many variables which may influence the outcome and unfortunately, we cannot solve for all of them without a crystal ball. Furthermore, lenders may have their own formulas to work out break-costs, which may be similar to the above but also may be quite different and may include other fees and charges.
That is why it is best to request a formal pay-out figure from your lender before deciding on whether to break your current fixed rate for another.
Usually, if your contracted fixed-rate is higher than the currently advertised fixed-rate (for the same term as you are contracted for), a break-cost would generally be expected. Conversely, if your contracted fixed-rate is lower than the currently advertised fixed-rate, a break-cost may not apply and in some rare cases, the lender may pay you out to end the fixed-rate early.
If in doubt, get in touch and we can help you understand your situation to ensure you are getting the maximum benefit from this historically low interest rate environment.
*The above examples are for illustrative purposes only and do not take into account the constant changes in interest rates both variable and/or fixed, other fees and charges that may apply to break-cost formulas, nor any specific break-cost formula utilised by any lender. As such, the above examples should not be relied upon nor utilised to work out the break costs of a specific loan. You should always seek your break-cost from your lender directly.
Disclaimer: The information provided herein is for general information purposes only and does not constitute specific advice. It should not be relied upon for the purposes of entering into any legal or financial commitments. Specific advice should be obtained from a suitably qualified professional before adopting any investment/financial strategy.