Squirrel: Fixing your Mortgage Long-Term? Beware of the Break Fee!

Squirrel’s John Bolton explains why you should beware of the break fee if you are tempted to lock in your mortgage to earn a lower long-term rate…

Beware of the break fee

In an uncertain interest rate environment, like we’re in right now, the question of how long to fix your mortgage for can feel like a really tricky one to get right.

Over the past few weeks, we’ve seen a few of the banks drop their longer-term mortgage rates to the point where they’re sitting below shorter-term rates.

For borrowers who are going to be stretched to their absolute limits by increasing mortgage costs, that slight reprieve might seem really tempting – but there are some hidden risks to locking in longer-term that people need to be aware of before they dive in.

And here, I want to warn borrowers about one in particular: break fees.

What is a break fee?

A break fee is the penalty that borrowers get hit with if they opt to break and repay a fixed-term mortgage before it matures. For example, if you sell your house, or if rates fall sharply and you want to refinance to get a better deal.

Because break fees usually only become an issue in a falling interest rate environment, chances are that if you’ve entered the housing market in the past decade, you won’t have experienced them before.

But depending on the size of your mortgage, break fees can set you back tens of thousands of dollars. So it’s an incredibly nasty surprise if you’re not expecting it.

Why do banks charge a break fee?

Break fees cover a real and legitimate cost to the banks that’s incurred when you break your loan term.

When you break your loan with the bank, the bank is forced to break the funding arrangements it has in place with wholesale funders. The bank gets penalised for breaking its loan early, so it passes that cost on in full to the end borrower – with no discounts or waivers.

How are break fees calculated?

The last time break fees caused major problems for homeowners was in 2009, just after the GFC. And back then, I got myself in a whole heap of trouble for comments I made about the way banks were calculating these fees. I’ve still got a few scars to show for it.

Basically, the calculation looks like this:

[Percentage fall in wholesale interest rates since you fixed the loan] x [Your loan balance] x [Years until the fixed rate matures]

It’s best illustrated with an example. You’ll note the calculation below is based on wholesale interest rates, a.k.a. the rate the bank borrows at, rather than the fixed-term mortgage rate. This is the bank passing on its cost: 

Let’s say a borrower opts to fix for five years at 7.50% and the wholesale funding rate, what the bank borrowed the money at, was 5.50%.

A year later, with four years left on their term and $600,000 left on their mortgage, the borrower wants to break the loan. At this point the wholesale funding rate has dropped to 4.25%.

So, the break fee would be calculated as follows:

The bigger the mortgage and the further rates fall, the scarier it gets.

Let’s say a borrower had fixed for five years at that same rate. If they chose to break the loan two years in, once wholesale rates had fallen from 5.50% to 3%, their break fee on a $600,000 mortgage balance would be $45,000.

Why are break fees something for people to keep in mind right now?

We’re not in a falling rate environment yet, but we are starting to see strong signs to suggest we’re nearing the top of the interest rate cycle.

The main indicator is that wholesale rates are now reflecting an inverted yield curve. This is when short-term fixed rates are higher than long-term fixed rates. That’s why we’ve seen some of the banks start to pull back their longer-term fixed rates in recent weeks.

It’s important to understand that we don’t typically stay at the top of an interest rate cycle for long. At some point, rates will fall across the board. And when they fall, they usually fall fast, off the back of a rapidly slowing economy.

When are rates likely to fall?

The high inflation we’ve experienced lately isn’t normal, and it won’t miraculously fix itself without more pain. That means rates are unlikely to drop during 2023, and we should all expect to front into higher rates for the next 12 months.

The Reserve Bank’s (RBNZ) official cash rate (OCR) is currently 4.25%, and expectations are that it will peak at 5.50%. This suggest that we’ve got another 1.25% increase to go in floating rates. Fixed rates, meanwhile, have already largely peaked – with any future OCR changes mostly priced in.

But the RBNZ’s forecast was done all the way back in November.

Since then, the economy has deteriorated faster on some metrics than expected (particularly business and consumer confidence). December’s inflation statistics came in roughly as predicted, with annual inflation running at 7.20%. While, seasonally adjusted, the final quarter came in at 6%.

So, we’re already seeing slowing levels of inflation. And there are still lots of us who have yet to feel the impact of coming off relatively low fixed rates, and having to absorb a dramatic spike in mortgage costs. Many will be coming off rates of around 3.95% and fixing at 6.50%.

So, my view is that we’re likely to see a 0.5% increase in the OCR this month to 4.75%. And, following that, one or (maybe) two 0.25% increases. Then, at some point, rates will fall.

Working on the RBNZ view that a neutral OCR is 2%, mortgage rates should slip back to 4.5% once inflation is under control.

If the economy stumbles and 2023 ends up in the predicted recession, we could start to see rates falling as early as the end of the year.

The possible flipside – if we get more growth than expected, and inflation proves to be a stubborn beast – could mean that rate falls are pushed further out, and the OCR goes higher. This is an alternative view that could eventuate.

So, how long should you fix your mortgage for?

The moral of the story? I’d be extremely cautious about fixing for three to five years, despite the fact that these rates will likely be lower in the short-term (and I’m not alone in that view).

Right now, I’d recommend fixing for one or two years, or splitting between these terms. This avoids or minimises the risk of break fees and, when rates do eventually fall, you’ll get the benefit sooner.

If you’re seriously concerned about the risk that the OCR could peak even higher (the alternative view), then opting for a two-year term would be my recommendation, to give you a bit more certainty.