Although the Reserve Bank of New Zealand cut the official cash rate last week and successive interest rate cuts by banks have brought some relief to many homeowners under heavy debt pressure, financial experts warn that breaking a fixed-term mortgage contract early could prove costly. As the interest rate cycle turns downwards, bank break fees have once again come under public scrutiny.
A Waikato entrepreneur was recently charged a break fee of as much as NZ$15,000 for switching banks, drawing widespread attention to banks' early repayment charges. She says ASB told her the fee was intended to recover the bank's costs arising from early repayment. As interest rates fall, more borrowers could face similar situations.
She revealed that her total borrowing was around NZ$2,500,000, covering several residential properties and a small business loan. At the end of July, ASB told her she would need to pay a break fee of just over NZ$10,000. Just two weeks later, however, the fee had soared to NZ$15,000. The business owner considered the NZ$15,000 fee excessive and sought a quote from another major bank. She says the other bank offered better lending terms, but because ASB refused to reduce or waive the break fee, she will be unable to switch banks for the next 15 months.
ASB says break fee calculations involve several factors, including the outstanding loan balance, the amount the customer wishes to repay, changes in wholesale interest rates and the time remaining in the current fixed-rate period. An ASB spokesperson explained: “When a customer chooses a fixed-rate loan, the bank needs to fund it by borrowing from other sources, such as depositors, wholesale money markets, other banks or through issuing bonds. If the customer decides to repay early or switch rates, the bank must still honour its funding commitments and may suffer a loss as a result.”
The Banking Ombudsman Scheme says that when customers repay early, banks may be unable to lend that money to someone else at the same interest rate, particularly when rates are falling. Banking Ombudsman Nicola Sladden stresses: “People are often surprised by break fees, so banks have a responsibility to disclose them clearly.”
Why do banks charge break fees?
These break fees, also known as early repayment charges, cover the costs of customers terminating or exiting a loan before the contract expires. Squirrel founder John Bolton says some homeowners could face penalties of tens of thousands of New Zealand dollars if they end their loans early. He warned homeowners against choosing long fixed-rate terms in January last year, having foreseen the current situation that could result in substantial break fees.
For example, a borrower with a NZ$600,000 loan who wants to end it three years early could face a break fee of up to NZ$50,000. Borrowers who chose shorter fixed-rate terms might need to pay break fees of around NZ$1500 to NZ$3000.
Bruce Pitchers of Canstar points out that break fees are generally not charged when interest rates are rising, as banks are happy to sell loans at higher rates. When rates fall, however, banks charge break fees to recover their losses. The larger the fall in interest rates, the higher the break fees.
Mortgage adviser Geoff Bawden says many borrowers do not understand the consequences of breaking a loan early, viewing it as a right without recognising their contractual obligations. Bawden stresses that break fees will come as a major shock to many newer borrowers who have never experienced the high interest rate environments of the past.
How can mortgage borrowers respond?
Faced with the temptation of today's lower interest rates, Bawden advises homeowners to calculate the costs carefully before deciding. He believes choosing a long fixed-rate term at the start of a falling interest rate cycle is unwise. Although banks have previously attracted customers by covering their break fees, that has yet to happen in this cycle. Instead, some homeowners may choose to use cashback offered by banks to new borrowers to cover part of their break fees.
Campbell Hastie of Hastie Mortgages recalls the 2008 global financial crisis, when interest rates fell sharply and many homeowners were angered by hefty break fees. He says banks are now more inclined to use cashback to retain customers, an approach that is more flexible and fairer than paying break fees directly.
Are you also considering switching banks or choosing a different loan product as interest rates fall?