Counting the cost of a fixed rate exit

 

As the ECB interest rate hits a record low, borrowers stuck on expensive fixed rates should explore the possibility of switching mortgages to save money, writes Caroline Madden

WITH EACH successive interest rate cut announced by the European Central Bank (ECB) since last October, borrowers on tracker mortgages have gleefully calculated how much extra disposable income they will have as a result, while mortgage holders locked into expensive fixed rate deals have looked on with envy.

Yesterday’s announcement that the ECB base rate has been slashed to an historic low will have given fixed rate borrowers even more cause to rue their interest rate choice. However, rather than just grin and bear it, they should investigate the possibility of switching to a cheaper variable rate (tracker rates are no longer available) or re-fixing at a lower rate.

True, they are likely to face a hefty fee for breaking out of their fixed rate, but in some cases the net savings can still be considerable, particularly for borrowers who fixed in 2008.

For example in July 2008, when the ECB base rate peaked at 4.25 per cent, five-year fixed rates were in the region of 6 per cent. This compares to variable rates of 3.25 per cent currently available.

“When interest rates start falling, people do – and they should – review the interest rate that they’re on,” notes Michael Dowling, mortgage broker and spokesman for the Independent Mortgage Advisers Federation. “There are very attractive variable rate options available to people.”

The first step for fixed rate borrowers is to establish whether or not their lender will charge a “break-out” fee. This fee reflects the cost to the bank of cancelling the fixed rate deal, and depends on a number of factors.

According to Dowling, banks use complex formulae for calculating it, but typically the penalty for breaking a fixed rate is between three and six months’ interest on the balance outstanding. “The simplest thing is just ask the lender what the cost is and they’ll work it out for you,” he advises.

Sometimes banks even manage to confuse themselves when calculating the penalty. A number of very fortunate Permanent TSB customers recently benefited from a glitch in the lender’s system that allowed them to break their fixed rate deals for a token charge rather than a large breakage fee. The wrong formula for calculating the penalty had been entered onto the lender’s system, with the result that switchers were only charged a nominal fee that didn’t reflect the true financial cost to the lender.

Permanent TSB’s switching facility is now temporarily suspended while the correct formula is being put in place. It will be reintroduced within the coming weeks. Any customer who switched, or got a quote for breaking their fixed rate, before the mistake was discovered, will not be charged any extra.

In general, though, borrowers can expect to pay a sizeable penalty.

Once they have established exactly how much this penalty will be, they need to compare it to the savings they will make from switching to a lower interest rate. “If the penalty to be paid is excessive, it may not actually be worth your while coming out of the fixed rate to try and take advantage of the lower rates,” Dowling says.

For example, one of his clients is on a fixed rate mortgage and considered switching. However, the penalty would have been €10,120, which meant that it was “just not viable”, he says.

Another client has switched from a five-year fixed rate to a variable rate, and the break fee in this case was a more reasonable €1,400. The legal cost of switching lenders was a further €1,000.

Despite these costs, Dowling says his client will make a net saving of €3,300 in mortgage repayments in the first year alone, and that’s before factoring in yesterday’s rate cut.

The ideal situation is if the borrower is able to switch to a variable rate offered by their existing bank, as they won’t face the costs associated with transferring a mortgage to a new lender, he advises. There may be an administration cost, but this is usually minimal, for example between €35 and €60.

However, in some cases borrowers will have to move to a lender offering a cheaper variable rate if breaking their fixed rate is to be financially viable.

“Unfortunately if you’ve to move from one lender to another, you are looking at costs of around €1,000 in moving and, in a lot of instances, that might make it prohibitive in terms of the benefit which you would gain from switching from a fixed rate to a variable rate,” says Dowling.

Some banks are still offering to make a contribution towards the cost of switching lenders, so it is worth checking this.

Another factor for borrowers to consider is whether or not they have enough equity in their home to move to another lender. If the value of their home has fallen, then their loan-to-value (LTV) ratio may be too high for them to qualify for a cheaper rate with another lender.

For example, if a person’s mortgage is €450,000 and the value of their property is €500,000, their LTV is 90 per cent. In some cases lenders insist on an LTV as low as 50 per cent to access their most attractive rates.

Even if the sums stack up and it makes sense on paper for a mortgage holder to break their fixed rate, they must also consider whether they’re in a position to pay the breakage fee upfront.

In some cases the lender may allow them to capitalise the fee, ie add it to the principal of the mortgage, but if there is little or no equity in the customer’s home (which is quite likely if they bought within the last two or three years), this won’t be an option.

Even if it is possible, it’s an expensive way to finance the switch, as it compounds their debt. The borrower will have to pay interest on the fee over the remaining term of the mortgage, which could be 20 years or more. Some banks such as Ulster Bank don’t offer this option at all, so borrowers will have to be prepared to fork out a lump sum.

An alternative to switching to a cheaper variable rate is to re-fix at a lower rate. This option offers the borrower the peace of mind that their repayments won’t increase during a set period of time.

While some commentators expect interest rates to remain at extremely low levels for several years, others believe that inflation – and therefore interest rates – will start creeping back up in the medium-term. On that basis, these commentators are of the opinion that fixing at current lows is a smart move.

According to Karl Deeter, operations manager with Irish Mortgage Brokers, a borrower who took out a 30-year fixed rate mortgage of €250,000 in July 2008 with ICS would have locked into a rate of 5.99 per cent. The equivalent rate now available from ICS is 4.55 per cent.

The difference between the monthly repayments on these two rates is roughly €223 a month (before mortgage interest relief), and if the borrower was in a position to shop around for a cheaper rate elsewhere on the market, the savings would be considerably greater.

Again any break cost would have to be considered, but it illustrates that re-fixing at a lower rate is an alternative worth considering.

On the downside, given the strong signals that the European economy will deteriorate further, locking into a fixed interest rate at the moment could prove to be jumping the gun.

Preferential interest rates: no longer preferable?

THE GOVERNMENT is expected to come under pressure to amend the rate used to calculate the benefit-in-kind (BIK) charge on preferential mortgages in its emergency budget at the end of this month.

For many taxpayers, particularly those on the higher tax rate, it is no longer worth availing of preferential interest rates offered by their employers, as the BIK payable outweighs the interest savings.

For example, AIB offers a preferential mortgage interest rate of 3 per cent to its employees.

Before the ECB started slashing interest rates last October, this would have represented a considerable discount to the rates available to the general public, and would have been a valuable benefit.

However, the standard variable rate offered to the public by AIB has fallen to 3.25 per cent.

The discount received by the employee is now just 0.25 per cent, but the BIK charge is assessed on the difference between the interest payable, 3 per cent, and the “specified rate”, which is currently set at 5 per cent.

The specified rate was reduced from 5.5 per cent to 5 per cent in 2008, but because of recent interest rate cuts, this is already out of date and does not reflect current market rates.

This anomaly means that for most employees, the income tax and PRSI payable on this “benefit” now exceeds the extra interest they would pay by switching to the public rate.

“In the current market conditions all individuals, whether employees of bank or not, should review their current mortgage provisions to see whether there are more beneficial rates available,” advises Ian McCall, tax director with Deloitte.

“As regards the banks themselves, in my experience it is best practice for any employer to monitor and review the compensation package it makes available to its employees to ensure that it is as attractive as possible but also compliant with the relevant tax rules.”

McCall predicts that the Government will face pressure to amend the specified rate for preferential loans this month.