Stay Calm So You Don't Get In A Fix

Stay Calm So You Don't Get In A Fix

Newcastle Herald
4 December 2008
Noel Whittaker

THE emotion that guides most investment decisions is fear.

When property and share markets are booming everybody loves to get in on the act for fear of missing out on big capital gains. When they fall, nobody wants to invest because they are terrified of losing their money.

It works in the same way with interest rates.

In early March when all the headlines were about rapidly rising rates and mortgage stress I wrote, "Despite the latest rise, indications are that we are getting close to the top of the interest rate cycle and rates will stay flat or start to reduce over the next year."

Regrettably, my advice fell on deaf ears, because the March-to-August period saw an unprecedented number of home owners rush to fix their interest rates in case their loan repayments went to a level where they would be unable to pay.

The rest is history. Interest rates are now tumbling, and the debt futures market is pointing to a cash rate of just 2.75 per cent by April 2009 that's a full 2.5 per cent drop from the current (at time of writing) rate of 5.25.

This represents a huge dilemma for those who let themselves be stampeded into a long-term fixed rate loan, as there are traps aplenty for the unwary.

An email from a reader is typical: "We had a fixed rate housing loan but had to pay it out because we had sold our home. A few months ago, when we listed our home, we asked the bank about termination fees. They told us a rough estimate was $6000 but the actual fee would vary with what rates were doing on the day. When we finally found a buyer and signed a contract the bank told us the fee had risen to $21,731. On settlement day when the loan was discharged, we discovered the fee was $29,307."

Emails from other readers tell about termination fees, commonly known as break costs, of between $36,000 and $80,000.

These costs can soak up a hefty chunk of your capital, but you need to understand that it's a fundamental financial principle that insurance always has a cost.

A fixed rate loan is a contract between you and your bank, and the essence of that contract is that the bank promises that your interest rate will not increase, no matter what rates in general are doing.

This means your bank could lose heavily if you wish to terminate the contract early.

If you took out a $300,000 five-year fixed loan, and rates fell by 3 per cent, the bank would lose $9000 a year if you terminated the contract before the end of the contract period.

Therefore, a termination in the first year could easily cost the bank $45,000 and they would expect to be compensated.

The purpose of this column is to alert you to the potential cost, because there is no simple way out of the problem.

I have heard suggestions that you could repay the bulk of the loan, leaving only a small balance until the end of the contracted period, but this is easier said than done. For starters, most fixed rate loans are paid out early because the borrowers are changing houses, so very few borrowers would be in a position to retain the original home and still buy a second one.

In any event, most fixed rate loans have conditions that penalise early lump sum repayments.

This is just another example of the way problems can be prevented if you take advice first.

You should never contemplate fixing your loan if there is even a remote possibility that you may need to quit early, because you will almost certainly be stuck with the break costs.

And don't think you can take advantage of falling interest rates by converting your present fixed rate loan to a variable rate one the break costs will cancel out any potential savings in interest.

Noel Whittaker is a director of Whittaker Macnaught, a division of HBOS Australia. This advice is general in nature and readers should seek their own expert advice before making financial decisions. His email is noelwhit@gmail.com.

Back to News Index | Back to Home