If interest rates fall and borrowers decide to repay a fixed rate loan, the bank will require the customer to pay a ‘break funding fee’ (sometimes called an ‘early termination interest adjustment’). Banks manage the interest rate risk on their fixed rate loan book by locking in similar term liabilities. If the customer discharges the loan prior to maturity after interest rates fall, the bank will be left with no asset matching the higher cost of funds. The break funding fee compensates the bank for this cost.
The role of break funding costs
Break funding costs first came to prominence in the early 1990’s when interest rates fell rapidly. Borrowers sought to refinance themselves at progressively lower interest rates. The ability of banks to charge break funding costs was crucial in preserving margins or covering costs. One mortgage securitiser at the time, FANMAC, wrote fixed rate mortgages with no break fees and experienced significant refinancing from customers switching into lower rate loans. The increased repayments flowed through to bond holders who found the duration of their investments reduced markedly. Significantly for FANMAC, the borrowers remaining were those who had difficulty refinancing and were of a lower credit quality, adversely affecting the performance of their book.
When explained to the borrower, most understand the need for a break fee, however they are often surprised at the size of the compensation sought by the bank. It also should be pointed out if rates were to rise, allowing the banks to replace the loan at a higher rate, it is usual for the customer to receive a payment.
Transparency of calculation method
Over the years there has been greater emphasis on disclosure of fees and charges so a borrower can make an informed decision when comparing loan products. This trend to greater transparency does not appear to apply to banks disclosing break funding calculations.
Recently, a client of one of the authors repaid over $2 million dollars in fixed rate loans. The loans were taken when interest rates were higher and the bank, as was its right, charged the customer a break fee exceeding $80,000. This is abnormally large and the client, while understanding why the fee was charged, justifiably requested the basis on which the fee was calculated.
In order to calculate the break fee only a few bits of information are required:
- the remaining term of the loan
- the balance outstanding
- the funding cost when the loan was written
- the funding cost when the loan was discharged.
If a loan has three years remaining, the balance is $200,000 and rates are 2% lower, the break cost will be $12,000.
Obviously, the bank must have access to the above information to calculate the fee, yet banks are reluctant to provide the calculation details. Numerous requests for this information to satisfy the client have fallen on deaf ears. If a particular bank consistently charges higher break fees due to the way it locks in funding, this is important information to be taken into consideration when taking out a fixed rate loan.
Even if the bank has made an honest mistake, there is no way of checking and the client is left feeling as though the bank is concealing something. Since the size of the discharge fees often surprises borrowers, it strengthens the case for greater transparency.
Calculation based on wholesale not retail rates
Another borrower known to one of the authors took out a fixed rate loan and understood the bank would pass on any economic cost if the loan was discharged early. The client decided to sell her property and entered into an unconditional contract to sell, however on discharge discovered that the bank had calculated a $13,000 break cost. The client believed that there would be no economic cost as retail rates had not moved since the time she took out the loan. This is not to suggest the bank was wrong. It does make the point that many borrowers, whilst believing they understand the terms of their loan, do not understand that break costs will be calculated based on the bank’s internal rates, not the customer rate. The rates used are also too much at the discretion of the banks.
Given interest rates are currently relatively low, if fixed rates rise, then a mortgage discharge allows the bank to replace the loan at a higher rate and accordingly the customer should receive the benefit. Understanding how this benefit is calculated is important. When interest rates rise a borrower with a low fixed rate loan views their loan favorably and they may be reluctant to discharge their loan. If they are confident they will receive an accurate economic benefit on discharge this may influence their behaviour.
Banks should be more transparent in how they calculate break fund costs and disclose the basis of those calculations to their clients. If the banks were obliged on loan settlement to disclose the funding rate, it would assist in estimating future break funding costs or benefits. Mortgage brokers should also properly explain break fees to potential clients, and quantify what these costs may be depending on different rate outlooks. Borrowers are then able to make a more informed decision.
Peter Cooper is Managing Director at Cooper Financial Connections and Keith Ward is the former Head of Retail Banking St George Bank.