Do the sums before thinking of changing from a fixed rate mortgage, writes FIONA REDDAN

THIS TIME last year, with interest rates on an upward path, many homeowners availed of the opportunity to fix their mortgages for periods of up to 10 years at rates of about 5.5 per cent. At the time, interest rates had been rising in the euro zone since 2003 and, despite the global credit crunch, were showing no signs of slowing down.

Then, in September of last year, US investment bank Lehman Brothers collapsed. Central banks around the world lowered interest rates in a collaborative effort to get economies back on track.

Nine months later, the global economy is still in crisis and the European Central Bank is still cutting rates. Its last decision, on May 13th, was to drop rates by 25 basis points – or a quarter of 1 per cent – bringing the overall rate down to just 1 per cent.

With rates even lower in Britain and the United States, at 0.5 per cent and 0 per cent respectively, there may be additional scope for rates in the euro zone to go even lower.

Homeowners on tracker rate mortgages are rubbing their hands with glee at each cut, as the terms of their contract means banks have to pass on each ECB rate cut in full. The same is true for most variable rate mortgage products – although a few banks have baulked at passing on the most recent cuts.

However, those on fixed rates are paying a heavy price for that decision relative to the other options. For a homeowner with a mortgage of €300,000 over 30 years, repayments on a five-year fixed rate of 5.5 per cent are €1,700 a month. But, repayments on a tracker mortgage (ECB + 1 per cent), are just €1,108.86 a month – a massive saving of almost €600 a month!

And the greater the mortgage, the greater the differential – homeowners with borrowings of €700,000 on a fixed rate are paying out almost €1,400 more each month than their tracker- rate neighbours.

So the advantages of switching to a variable or tracker rate are clear, but it is not as simple as just requesting a change. While tracker rates are no longer available, or if they are, they are at unattractive rates such as First Active’s ECB + 1.95 per cent, homeowners must pay a fee to the bank for moving from fixed to variable.

With fees often running into the thousands, homeowners need to think carefully before making the decision to switch without losing sight of the fact that savings could potentially be far in excess of the fee. For those considering such a change, the following steps should help with the decision.

1) Calculate your “breakage fee”

Although banks say that they are not applying penalties to those looking to break a fixed rate contract, they are charging fees – very significant in some cases – to reflect the cost to the bank of breaking out of the contract.

According to Bank of Ireland, the bank “simply passes on the actual cost it will incur as a result of the customer breaking the fixed rate contract”. This is because in order to provide a fixed rate mortgage to a customer, the bank also borrows the money at a fixed rate.

Determining the cost to the bank of breaking the contract depends on factors such as how many years are left in the fixed-term contract, and the size of the mortgage.

Breakage fees for ending a fixed rate contract differ from one mortgage provider to another, and if you check the terms of your contract, you might find a complicated formula which the banks use to calculate the fee.

In general, however, the fees are equal to about a six-month interest charge, with the fees on newer mortgages greater than on a mortgage taken out some time ago, as in the early years repayments are heavily weighted towards repaying the interest part of the loan.

For example, a breakage fee on a 30-year mortgage of €700,000 would be about €18,500 if the mortgage was started in 2007. If it was started in 2002, however, the fee will be significantly less, at about €13,200.

2) Make a decision on where you think interest rates are going

With interest rates in the euro zone at historic lows, many commentators suggest that the only way forward for rates is up, with fears that high levels of inflation will see rates climb higher than the previous peak of 4.75 per cent set in 2000.

If this turns out to be the case, the benefits of shifting to a variable rate may be short-lived, as lenders will pass on interest rate hikes much more quickly than they passed on cuts. If such is foreseen, a borrower might be better advised to lock into one of the new lower fixed rates, such as the 3.69 per cent rate on offer from AIB.

However, as Dominic Coyle argued in these pages some weeks ago, banks generally have a better read on the future direction of rates than individual borrowers, and generally make more money on fixed rather than variable rates.

With such low fixed rates on offer, it would suggest that the banks believe that low interest rates are here to stay.

3) Work out how much you will save

Once you know how much breaking your contract will cost, you can work out how much you can potentially save by making the switch. While the exact amount you could save will depend on the future direction of interest rates, if you think that interest rates will remain low for the next few years, it might make sense to break your contract.

Take the example of the aforementioned €700,000 mortgage. Moving from fixed to a variable rate of 2.65 per cent would save about €1,153 a month, if interest rates stay at their current level. On that same basis, savings of €13,845 would be made over 12 months, €20,754 over 18 months, and €41,508 over 36 months.

Thus, a homeowner on a newish mortgage could expect to benefit from the switch within about 18 months (with a breakage fee of about €18,500), while someone with an older mortgage will start saving money sooner (breakage fee of about €13,200).

If you really want to capitalise on your switch, however, you should consider forgoing any monthly savings you might make due to the lower interest rate in order to overpay your mortgage each month.

The ability to do this is a major advantage of variable over fixed rate mortgages, and if you can afford to do it, you can make significant savings while also shortening the term of your mortgage.

On the €700,000 mortgage, if you switch from a fixed rate of 5.5 per cent to a variable rate of 2.65 per cent, but keep your repayments at the current level of €4,000, total savings of about €500,000 in interest could be made over the life of the mortgage, while you would also reduce the term by almost 12 years. While it is highly unlikely that rates would stay so low over the long-term, serious savings can still be made.

4) Work out your “LTV”

To make a switch worth your while, you really need to be moving to one of the best variable rates available, but there are restrictions associated with these.

As banks enforce stricter lending policies, they are offering their most attractive rates to those with smaller loans relative to the value of their properties. For example, AIB, which has one of the best variable rates at 2.25 per cent, only offers this to homeowners with a loan to value (LTV) ratio of less than 50 per cent, while at Bank of Ireland, a rate of 2.5 per cent is available to those with LTVs of less than 50 per cent.

If you bought your house some time ago, it is likely that you will qualify for the better rates. For example, if you have a mortgage of €200,000 outstanding on your house and it is currently worth €500,000, your LTV is just 40 per cent. However, if you bought your house in the last five years, it is likely that your LTV is closer to 80 or 90 per cent, while those who bought at the peak of the market may be in negative equity, with an LTV of more than 100 per cent, and would find it difficult to switch.

5) Factor in cost of switching banks

Ideally, you will switch from a fixed to a variable rate with the same lender, but if your bank or building society is one of the worst offenders when it comes to passing on interest rate cuts to its variable rate customers, you may have to consider switching lenders in order to benefit from the most attractive rates.

For example, variable rates at First Active remain high. Homeowners with an LTV of less than 80 per cent are paying 3.7 per cent, while interest is charged at 3.8 per cent for those with an LTV of more than 80 per cent. Over at Halifax, existing variable rate customers are paying interest on their mortgage at 2.43 per cent, but new customers with an LTV of between 75 and 90 per cent are charged 3.55 per cent.

Switching banks can cost, because of valuation fees, legal fees and other charges such as a “deeds release” fee from the Land Registry, although some banks offer incentives in order to attract more business. Halifax is currently offering €1,000 towards the cost of legal fees, as well as refunding up to €150 in valuation fees. Homeowners should note, however, that if you move your mortgage from Halifax within five years you will have to repay this contribution.

Knowing your LTV is again important when it comes to switching, as homeowners with an LTV of 92 per cent-plus may find it difficult to switch banks, while those in negative equity will find it impossible to do so, as lenders will be unwilling to take on the risk associated with their mortgage.

6) Consider alternative options

If, having gone through the above steps, you decide that it would not make financial sense to make the break, there are still other options you could consider.

With lower fixed rates now available, you could ask your bank to switch you to its new lower rate. While this will still incur a cost, it is likely to be lower than switching to a variable rate, and you might still make savings. For example, AIB is currently offering a five-year fixed rate of 3.69 per cent. Switching from a fixed rate of 5.5 per cent would save you almost €20,000 in interest payments over the next five years (with a €300,000 mortgage over 30 years).

Another alternative is to ask your bank to move half of your mortgage to a variable rate, and keep the rest on your fixed rate, as again, the fee to do so may be lower. Most mortgage providers offer products along these lines, such as KBC’s “Mix Match” option.