Homeowners caught in a fix

Mortgage rates have come down so quickly and by such large amounts that thousands of people are now paying fixed rates which they feel are well over the odds.

Those who took out fixed rates in the early 1990s around the time of the currency crisis are in a very bad position, but even those who took out fixed rates two and three years ago often feel aggrieved.

By taking out a fixed rate these borrowers were betting that rates would stay the same or move higher while those who chose variable rates were betting that rates would fall.

Of course fixed rates are not just a bet, they are also a form of insurance policy and borrowers have had the benefit of knowing what their monthly payments would be.

It is also worth remembering that while some people may be thinking of getting out of fixed rate loans it is also the case that now may be the time to fix, particularly for longer periods of time. One and two-year fixed rates are the most popular choice. However they rarely make sense unless you need that extra level of comfort just for a short period. But longer term rates are on the increase again at the moment and current levels may offer good value.

Whether it pays to exit a fixed rate depends on several factors. The most important is perhaps the ongoing attitude to risk. After all if you fixed your mortgage in the first place it may be that you would not cope very well with a large increase in rates.

But for those with just a year or two left this is perhaps less important.

The amount of penalty is obviously also another key consideration. The bigger the gap between current rates and the fixed rate you are paying the bigger the potential advantage, but that also depends on what method your lender uses to work out your penalty.

With some lenders it can also be worth while approaching your bank manager and asking for consideration. Some lenders are particularly strict on this but others are more likely to do a deal.

EBS for example, is very strict, arguing that it cannot do deals with one set of customers which would give them an advantage over other customers.

AIB is also considered to have a very strict policy. AIB says if it mitigates the penalty it must write this off as a bad debt, which is something most branch managers are very reluctant to do.

However, if you are taking out a new loan it will work out an average rate. This means you could end up paying slightly more than current rates, but less than the old rate you had fixed in at originally.

Bank of Ireland may be slightly more lenient and will sometimes waive the penalty if the new mortgage is staying with the bank, as will some other lenders.

In calculating the penalty the bigger banks work out how much it will cost them to let you out of a fixed rate. This is based on the difference between the rate you are paying and the rate the bank can get from a new borrower. When rates are falling this can work out more expensive than a penalty of a fixed number of months' interest, but it does at least have the virtue of being seen to be fair to all borrowers.

There is also an important difference between lenders who use the cost of the funds on the mortgage market and the cost in the interbank market.

Using the interbank can be more expensive in a wide range of circumstances and the cost in the mortgage market is probably the best option for customers.

Other lenders use a basic three or six months' interest formula. This can be to the customer's advantage when rates are falling and will often work out cheaper.

However, in the current environment of rising interest rates it can prove to be very expensive. First Active, EBS, ICS and Irish Nationwide all use this approach.

Some lenders use a combination of, say, three months' interest or the cost of funds, whichever is less, and this is probably the best combination from the customer's point of view.

One reason that many of the lenders are so strict about applying the penalty is they say that letting someone off the charge is equivalent to "welching" on a bet.

Of course, if you move house and take the loan with you, you will not have to pay the penalty. The lenders say they have "hedged" all parts of their lending.

This means that they have had to take out the equivalent of insurance cover on which way rates are likely to move in the future money markets. This does cost the lender money. Without this cover they are effectively taking a bet on the markets. Few lenders do this and fewer still on longer-term money.

Some also claim that allowing customers to get out of fixed rates without a penalty would be encouraging them to bet against the lender.

Despite the large penalties, many people are now considering paying the penalty to get out of their fixed rates, but this does not always make financial sense. Some of those who are now getting the worst deal include those who went for long-term fixed rates following the currency crisis. Variable rates at that time ranged form 13 per cent to 17 per cent and those who were able to fix at rates below 10 per cent were often quite pleased.

But now with the benefit of hindsight it does not look quite such a good decision. No matter how an institution works out a penalty, these people are not doing well.

The different methods can throw up very different penalties. One reader wrote to Business This Week concerning his mortgage, taken out in 1993 at a fixed rate of 9.75 per cent.

At the time it seemed a good bet. Interest rates had hit 17 per cent earlier that year in the wake of the currency crisis and anyone who predicted rates of 3.99 per cent would not have been taken seriously.

But to unburden himself now is very expensive. If the borrower had £100,000 of this loan left now he would have to pay £13,430 on AIB's calculation method. A similar amount would be owed using Bank of Ireland's and Ulster Bank's calculation. The amount is very high because of the huge difference between the 9.75 per cent and the current cost of long term funding.

Anyone else in this position can work out the amount owing using an approximate amount of £134 per £1,000 outstanding on the mortgage.

On this 10-year mortgage with EBS, 12 months' is owing, leaving a penalty of £9,750. This is equivalent to about £97 per £1,000 outstanding.

Another reader has a 7.5 per cent loan which is due to expire in January 2001. With AIB the breakage cost would be £3,199 on £100,000 outstanding or £32 per £1,000.

With EBS this would be £3,750 or £37.50 per £1,000. Because of the narrower gap between the old and new rate the cost of funds basis is better value for the customer.

Another mortgage holder has a loan of 6,25 per cent which is due to expire in May 2000. The breakage cost with AIB is £898 or £8.98 per thousand with EBS it is £1,562 or £15.62 per thousand.

It is clear that the best value for customers is that offered by those institutions which offer the cost of funds or six months' interest whichever is lower.

Of course whether or not it is beneficial to pay these penalties depends on how long variable rates stay as low as they are currently.

If your lender uses cost of funds you must look at where the fixed rates are now, compared with variable rates.

For example if you had that expensive 10-year mortgage at 9.75 per cent the penalty is based on a four-year money which is now 5.65 per cent.

You pay the penalty for that difference and thus the benefit is the 1.6 per cent between the current variable of 3.99 per cent and the 5.65 per cent.

Thus rates would have it rise by more than 1.6 per cent for it not to be worthwhile paying the penalty.

It is also possible that you would get a better return on an alternative investment, but if you have money simply sitting on deposit then it could well be worth your while paying the penalty or indeed asking your bank if they can do anything for you.

Those who have perhaps the easiest choice are those who fixed in the past year or so and are now regretting it.

Some of these may have fixed at rates close to 5 per cent and are now looking at variable rates below 4 per cent. If you are in this position and your lender operates the cost of funds rule you should be swap onto the variable rate without any penalty.

This is because fixed rates have risen somewhat in recent months allowing the lender to re-lend your tranche of money at a higher rate. Borrowers with lenders who use the three of six months' penalty clause still have to pay to get out of these loans.