Breaking up is hard to do
Think hard before committing yourself to a fixed rate home loan, because backing out of it could be expensive.
If you've signed up to a certain rate over a certain time frame, you can't simply change your mind if floating rates fall or your financial circumstances change.
Instead you'll potentially have to pay a hefty break cost - or 'early repayment adjustment' as the banks put it - to get out of the commitment. Basically if your decision to break your loan term will leave your bank out-of-pocket, you could be expected to make up the difference.
Why can't you just walk away?
When a bank lends you money for a fixed period, it protects itself by offsetting the interest rate risk on the loan amount through something called an interest rate swap.
"Let's say a customer wants to fix a loan for three years. In simple terms the bank then goes out to the market and swaps the interest rate position it will provide the customer with another party for three years, and we commit to that for that period," says Shaun Drylie, ASB's general manager of product and strategy for retail and business banking.
This means if you want to get out of the fixed rate period, the bank is still obliged to pay the investor the agreed swap rate for the remaining term. If interest rates have dropped there can be a cost to exit these arrangements.
"This cost can be seen as the difference between the rate we can re-lend that money back out into the market for the period remaining and what the customer is currently paying. This becomes the early repayment adjustment," Drylie says.
He adds that margins on home loans are a lot tighter than people realise - often around the 1 per cent mark or less, giving banks little leeway not to pass on the costs involved. "A lot of people think the interest they are paying all goes to the bank, but only a small percentage does, the rest is meeting the cost of the funds."
How to avoid break adjustments
It doesn't have to be an all or nothing proposition. If you want out of a fixed term because you want to repay the loan faster, you might be able to negotiate higher payments rather than breaking the term.
Drylie says in most cases, it's best to be proactive rather than reactive and think about what you're getting into before you sign. He suggests taking a good look at your personal circumstances and how they gel with market expectations of where rates might go in the future.
If you take a short-term rate, consider what will happen if rates jump up more than you anticipate in that time: would that put you in a financially uncomfortable situation when your term expires?
When trying to decide on floating or fixed, or on how long to fix for, ask yourself: what's more important to you - certainty or flexibility?
"It's in these sorts of questions and conversations that, generally, people land at a point they are comfortable with," Drylie says.
You don't have to put your whole loan on one rate or one term. "Many customers are putting some of their loan on to shorter term fixed rates or on a floating rate and moving some of their loan onto longer term rates, in that way covering their risk - a bit of diversification if you like," Drylie says.
When won't you pay?
At the moment, interest rates are on the rise, so if you find yourself in a situation where you need to get out of a fixed-term rate early you might not need to pay hefty fees to do so.
If the bank can relend the money at the same rate - or higher - for the remaining term of the fixed rate contract, then Drylie says you may not pay any adjustment.
- Be proactive: Think about what you can handle if interest rates rise before you sign up.
- Be creative: Diversify your loan so it's not all on one rate or term.