Home loans explained: Break costs and how you can avoid paying them

A fixed rate home loan can be a great option for borrowers and homeowners who want extra stability with their repayments. However, fixed periods (usually lasting between 1-5 years from the start of your loan term) can come with limitations that make it difficult to make changes to your loan and how you repay the loan without incurring extra costs.

These extra costs charged by lenders are known as break costs and are applicable to most fixed interest rate home loans.

What are break costs?

A home loan break cost is a fee charged by a lender to a borrower if the borrower 'breaks' the fixed rate term in their home loan prior to its completion, or if they make extra repayments above their maximum allowed amount.

Keep in mind, break costs are different to early exit fees and discharge fees.

• Related: What is the total cost of a home loan?
• Related: How much does it cost to refinance?
• Related: A step by step guide to refinancing your home loan

How are break costs calculated?

The reason there is a cost associated with breaking your fixed rate is because the lender will make a financial loss.

Lenders calculate break costs is by calculating the difference between the wholesale interest rate at the establishment of the loan and at the time of breaking, along with accounting for how much time remains on the fixed term. If the interest rate hasn’t decreased, you could avoid paying break costs.

Break costs are calculated based on these primary factors:
1. How much time was left remaining in the fixed term 2. The difference in the lender’s cost of funds at the time of breaking in comparison to when the loan initially settled.

How can you avoid paying break costs?

1. Compare variable rates

The best way to avoid paying break costs is to plan ahead at the time of establishing your loan and to work out what you are likely to need from your loan in the future.

Fixed rate periods are usually between 1-5 years, so if there’s a chance that you’ll want to refinance during the fixed period, find out what the break costs could be.

If you suspect that you may need to break your loan in the future, consider forgoing fixed rate loans altogether. A home loan with a variable interest rate can offer you a lot more flexibility than many fixed rate loans and will typically allow you to make uncapped additional repayments and refinance at any time without penalty.

2. Consider a split loan

If you yearn for repayment stability, another option to consider is a split rate mortgage. Split loans are a common home loan type that can offer you the benefits and the stability of a fixed rate with the flexibility and bonus features of a variable rate loan.

These loans will typically allow you to make unlimited extra repayments and add loan features like an offset account or redraw facility that standard fixed rate loans do not usually offer.

3. Consider loan portability if you think you might move homes

For certain borrowers, a portable home loan can be an attractive feature that allows you to transfer an existing loan onto a new property if you move home. It also helps you avoid paying loan establishment fees.

When are break costs incurred?

1. When you make extra repayments

If you decide to make additional payments on top of your regular repayments (either as a lump sum or smaller payments spread out over time) during your fixed period, you may be subject to break costs.

Some lenders will allow you to make extra repayments on certain loans, but there is usually a limit. For example, you may be able to pay an extra $10,000 per year with some fixed rate loan options, or pay a total additional $20,000 extra over the entire fixed period.

2. When you refinance

If you switch to another loan before your fixed term is over, you are likely to be charged break fees. Reasons that you might want to refinance can include switching to a variable interest rate, a change in your financial situation, wanting to make additional repayments or you might want to get a better deal.

It is a good idea to assess whether it is worth incurring the break costs to refinance. Sometimes it is a good idea to wait until the end of the fixed period, before you decide to refinance. It really depends on your individual situation.

3. When you sell your property

If you decide to sell your property during your fixed rate period, you may incur break costs if your loan is not portable. A portable home loan allows you to transfer your current loan amount over to a new property. This means you can avoid the costs associated with "breaking” your loan and establishing a new one.

4. When you pay off the entire loan before the end of the fixed term

If you intend to pay off your loan in full, before the end of the fixed term, you are likely to be charged break costs. These fees can be high and are intended to at least partly cover the losses experienced by the lender from you breaking the loan.

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The information in this post is general in nature and should not be considered personal or financial advice. You should always seek professional advice or assistance before making any financial decisions.