How break costs on fixed rate loans are calculated

A break cost is the amount a lender charges when a fixed rate home loan is repaid, refinanced or switched before the fixed period ends. It is calculated, in general terms, as the difference between the interest rate that applied when the loan was fixed and the rate prevailing when it is broken, applied to the amount repaid early, over the time remaining in the fixed period. If rates have fallen since the loan was fixed, the cost can be substantial. If rates have risen, the cost is generally low or nil.

The exact formula is set by each loan contract, so the only reliable figure is a written quote from the lender. Understanding the mechanics still helps a borrower to weigh the cost against the saving from a refinance.

Why break costs exist: wholesale funding for fixed rate loans

When a lender agrees to a fixed rate, it commits to receiving a set interest rate for a set term regardless of what happens in the market. Lenders generally manage that commitment by arranging funding or hedging for a matching term. The Reserve Bank of Australia (RBA) has explained that much of banks' wholesale and deposit funding is linked to bank bill swap rates, either directly or through hedging, and that longer term swap rates are key benchmarks for pricing fixed term products.

If a borrower repays early, the lender is left with funding or a hedge arranged at the original rates and must re-lend the returned money at current rates. Where rates have fallen, the lender earns less on the re-lent funds than it is paying on the matching arrangement, and the break cost passes that loss to the borrower. The Australian Securities and Investments Commission (ASIC) describes a break fee in Regulatory Guide 220 as a fee that lenders say recovers the economic cost of a customer terminating a fixed rate loan before the end of the fixed rate term. ASIC notes that it is not charged on variable rate loans.

The general method lenders use to calculate a break cost

ASIC's guide states that break fees are usually calculated by reference to the difference between the fixed interest rate and the prevailing interest rate at the date of early termination, over the remaining term for which the rate is fixed. ASIC adds that either rate could be a retail or a wholesale rate, depending on the contract. Where wholesale rates are used, a break cost cannot be estimated reliably from advertised home loan rates.

A simplified version of a wholesale method has four steps:

1. Identify the lender's wholesale cost of funds on the day the rate was fixed, for the full fixed term.
2. Identify the wholesale rate on the day the loan is broken, for the period remaining.
3. If the second rate is lower than the first, multiply the difference by the amount being repaid early and by the remaining time.
4. Discount the result to its present value, because the lender receives the compensation immediately instead of over the remaining term.

Actual formulas are more detailed and use the lender's own internal rates, which are not published. ASIC expects lenders to keep records showing how break fees are calculated.

Illustrative example of a break cost calculation

The following example is hypothetical, uses round numbers and a simplified method, and does not reflect any current rate or any lender's actual formula. A borrower fixed $400,000 for three years and wishes to refinance after one year, leaving two years of the fixed period.

• Wholesale three year rate when the loan was fixed: 4.50 per cent.
• Wholesale two year rate on the day the loan is broken: 3.50 per cent.
• Difference: 1.00 percentage point.

The simple estimate is $400,000 multiplied by 1.00 per cent multiplied by 2 years, which is $8,000. Expressed monthly, that is about $333.33 for 24 months, and discounting those amounts at 3.50 per cent a year gives a present value of about $7,716. Scheduled principal repayments, ignored here, would reduce the figure.

The table applies the same method, before discounting, to other hypothetical scenarios.

Scenario	Rate movement	Time remaining	Simple estimate
Rates fell sharply	Down 1.00 point	2 years	$8,000
Rates fell slightly	Down 0.25 point	2 years	$2,000
Rates fell sharply, near expiry	Down 1.00 point	6 months	$2,000
Rates rose	Up 0.50 point	2 years	Nil

What drives the size of a break cost

The Australian Competition and Consumer Commission (ACCC) summarised the drivers in its Home Loan Price Inquiry final report: the amount depends on how interest rates have changed since the borrower locked in the fixed rate, the remaining fixed rate period and the home loan balance.

• Movement in rates. The further rates have fallen since the loan was fixed, the larger the cost.
• Time remaining. A loan broken early in a five year term attracts a much larger cost than one broken a few months before expiry.
• Amount repaid early. The cost scales with the balance, or with the portion being prepaid.

ASIC notes that break fees can, in some circumstances, amount to tens of thousands of dollars. It also observes that a fixed rate loan may not suit a borrower who expects to repay or refinance within the fixed period. This matters when comparing fixed and variable rates.

When break costs are low or nil

ASIC's guide states that a consumer breaking a fixed rate loan with a rate lower than the prevailing rate will pay a lower or nil break fee. In practical terms, break costs tend to be small or absent when:

• wholesale rates have risen since the loan was fixed;
• only a short period of the fixed term remains;
• the amount repaid early falls within the contract's extra repayment allowance; or
• the fixed period has already ended and the loan has reverted to a variable rate, in which case no break cost applies.

A nil break cost does not mean that leaving is free. A discharge fee and the new lender's fees may still apply. Market context is summarised on the interest rates page.

Partial prepayments and extra repayment caps on fixed loans

A break cost can arise without closing the loan. Fixed rate loans generally restrict additional repayments, and a repayment above the permitted amount is treated as a partial break. In a March 2023 Bulletin article, the RBA reported that, among major lenders, the median prepayment allowance was $10,000 per year of the fixed term. That finding is dated, and allowances differ between lenders, so the current limit should be confirmed in the loan contract.

Under the simplified method above, a borrower with a $10,000 allowance who makes a $50,000 lump sum repayment would have $40,000 treated as an early repayment. With a fall of 1.00 percentage point and two years remaining, the illustrative cost before discounting would be $40,000 multiplied by 1.00 per cent multiplied by 2, which is $800. Events that may trigger a full or partial break include:

• selling the property or repaying the loan in full;
• refinancing to another lender;
• switching to a variable rate or a different fixed rate with the same lender;
• exceeding the extra repayment cap; and
• in some contracts, changing the repayment type.

Borrowers who expect to make large additional repayments may consider splitting the loan, so that extra funds are directed to a variable portion with an offset account or unrestricted repayments. The extra repayment calculator shows the effect.

How to obtain a break cost quote

1. Locate the break cost clause in the loan contract and the lender's fee schedule. ASIC considers that lenders should explain, in plain English, the amount of the fee or, where that cannot be known in advance, the method of calculation.
2. Contact the lender and request a written break cost quote, together with a payout figure, for a nominated date.
3. Ask how long the quote remains valid. Wholesale rates move daily, so quotes are generally indicative and the final amount is set on the day the loan is repaid.
4. Ask for the inputs used, including the rates at the start and at the quote date, the remaining term and the amount treated as prepaid.
5. Request a fresh quote shortly before settlement of a sale or refinance.

Under section 70 of the National Credit Code, as described by ASIC, a lender is prohibited from unilaterally increasing a break fee on a fixed rate loan or changing the method of calculation in a way that increases the fee. A borrower who disputes a quoted amount may use the lender's internal dispute resolution process. ASIC notes that the Australian Financial Complaints Authority has published information about how it considers complaints about break fees and the circumstances in which it might reduce or vary a fee.

Weighing a break cost against the saving from refinancing

A break cost is roughly the value of the interest advantage the borrower would gain by moving from the old fixed rate to current rates for the remaining period. For that reason, paying a break cost to reach a lower rate often produces little net benefit during the remaining fixed period. Any gain comes from a larger rate difference than the wholesale movement implies, from better features, or from savings after the fixed period. The refinance calculator allows the quoted break cost to be included with other switching costs so that the break-even period is visible.

The ban on exit fees for variable loans since 1 July 2011

Break costs are sometimes confused with exit fees. According to ASIC's Regulatory Guide 220, regulation 79A of the National Consumer Credit Protection Regulations 2010 prohibits early termination fees on credit contracts secured over residential property that were entered into on or after 1 July 2011. Treasury states that the ban was introduced because some lenders were using exit fees to lock customers into their loans. ASIC notes that the prohibition extends to deferred establishment fees and that a consumer who has paid a prohibited fee can recover it.

The prohibition does not apply to:

• a break fee on a fixed rate loan;
• a discharge fee, which covers the lender's reasonable administrative cost of ending the contract; or
• fees incurred before termination where the contract ends before any credit is provided.

A borrower with a variable rate loan written on or after 1 July 2011 can therefore generally leave on payment of a discharge fee and government registration charges, while a fixed rate borrower remains exposed to break costs. Older loans may still carry early termination fees, which remain subject to the unconscionable fee and unfair contract term provisions.

This article is general information only and does not take personal circumstances into account. A licensed adviser or mortgage broker can assist, and the frequently asked questions page covers related topics.