Customers who borrow money at a fixed interest rate for a fixed term enjoy the benefit of knowing exactly what their repayments will be over the period of the loan. They are not affected by any rise or fall in interest rates during that time. In return, banks get a pre-determined return on their money.
But if customers repay their loan early (or make a significant lump sum payment before the end of the term), banks may not be able to lend that money to someone else at the same rate. That’s because interest rates may now be lower than when the loan was taken out.
To recoup lost earnings, banks apply an early repayment charge (also known as a break fee). In order to apply an early repayment charge, it must be stated in the terms and conditions of the loan contract – hence the importance of reading a loan contract carefully. The terms and conditions may also allow for an administration fee when a loan is repaid early. This is a flat fee and quite separate from an early repayment charge.
Calculating the charge
The Credit Contracts and Consumer Finance Act 2003 regulates early repayment charges on consumer loans. Consumer loans are loans that have been advanced for personal, domestic or household purposes.
The Act allows lenders to recover their costs when a borrower repays a loan early. The Act contains a formula for lenders to use when calculating how much they lost, but it is not compulsory to use this formula (known as a “safe harbour” formula). They can use their own, but their formula must result in a reasonable estimate of how much they lost as a result of early repayment. Lenders must tell borrowers whether they are using the safe harbour formula or their own formula, and they must also explain how they will calculate the charge.
Calculating early repayment charges involves a complex formula. Many – but not all – banks base the charge on the difference between the wholesale interest rate on the loan and the wholesale rate applicable when the loan is repaid early (other factors are also included in the calculation). If rates have risen since the loan was taken out, a charge won’t be applied because the bank can lend the money again at a higher rate.
Banks can’t give prospective borrowers an indication of how much it might cost to break a loan early because the calculation requires two inputs that cannot be known in advance: the point at which the borrower will decide to repay the loan early, and the interest rate applicable at that future point in time. Only with that information can banks calculate any loss and any corresponding charge.
There is nothing preventing borrowers from trying to negotiate a lower charge, but banks are under no obligation to agree. Any reduction is entirely at banks’ discretion. Borrowers should assume banks will apply the charge in full.
Customers are frequently surprised at the size of the charge they face during times of falling interest rates. That surprise often leads them to complain to us. But it is important to remember that an early repayment charge is not a problem in itself – provided the loan contract stipulates that the bank can take such a step if the loan is repaid early.
Complaints we receive include:
- A bank failed to tell a customer about the charge, either when the customer took out the loan or repaid it early. For example, a bank might have told a customer about an administration fee, but not about the early repayment charge. Or a bank might have failed to tell a customer about the charge when the customer said he or she might repay the loan early.
- A bank failed to tell a customer about how it would calculate the charge, or didn’t explain the calculation properly. Bank staff might not, for example, have been able to explain how the charge was calculated, and did not refer the query to someone who could.
- A bank made a mistake in the way it calculated the charge. We will check whether the bank calculated the charge according to the contract. We may also refer complaints about methodology to the Commerce Commission, which enforces the Credit Contracts and Consumer Finance Act 2003 and has greater powers to take action against lenders that have breached it.
- A bank gave incorrect advice about the type of loan most appropriate to a customer’s circumstances. A customer might, for example, have told a bank of his or her intention to sell a property within a specific time, and the bank recommended a fixed-rate loan whose term extended beyond the point when the customer was intending to sell.
Read loan contracts carefully so early repayment costs and any administration fees don’t come as a nasty surprise.
Bank gave sufficient warning about charge
Ravi and his partner Hana approached their bank about its fixed home loan rates. They were given the current rates and told they would face an early repayment charge if they broke the term of the contract.CASE 2
Customer not told break fee valid for days only
Jamie wanted to refinance his home loan with another bank. He had a fixed rate loan and realised he might have to pay an early repayment charge.CASE 3
Bank properly informed customer about early repayment charges
Zhang took out three housing loans with his bank. The loans' interest rate was fixed for three years. Four months later, Zhang asked the bank what it would cost to repay the loans early. He was told what the early repayment charges would be. He repeated this request three more times during the next two months. The answers were higher than the first estimate. Zhang eventually refinanced with another bank. The early repayment charges were $5,000 higher than initially quoted.
Concerns about lending decisions
We receive complaints about banks both refusing to lend and allowing customers to borrow when the customers say they could never have afforded the repayments.
Lending decisions are usually a matter of commercial judgement for banks, something beyond our powers to investigate. We can, however, investigate administrative errors in the lending application process. This includes complaints about a refusal to lend and also what is sometimes termed "irresponsible lending".
How banks evaluate applications
In considering a lending application, a bank should take into account, among other things, the customer’s income and whether it is secure, what other debt the customer has, and the customer’s credit rating.
Banks rely on getting honest, accurate information. Usually, a customer is required to sign a declaration confirming the information he or she has given in support of an application is accurate. Banks should make further enquiries if the application is incomplete or something in it suggests the information is incorrect.
Banks must provide credit or increase a customer’s credit limit only when the information they have available leads them to believe the customer will be able to meet the terms of the lending.
Banks must consider all relevant information available to them from throughout their various departments when making a lending decision. For example:
- it may not be enough for a bank to consider only credit card department information when other departments also hold information relevant to a loan application
- the fact a customer has previously met payments on a current credit facility may not in itself establish that the customer can repay a higher level of debt; a bank should check other information it holds on the customer.
Our approach to lending complaints
In order to conclude that a bank lent to a customer who lacked the means to meet loan repayments, we must be satisfied the bank knew, or should have known, the customer could not afford the loan repayments when he or she requested or drew down the loan. This applies to any type of lending, whether secured or unsecured, including mortgages, personal loans, business lending, credit cards and overdrafts.
In order to conclude that a bank acted incorrectly in refusing lending, we must be satisfied an administrative failure occurred in the bank’s assessment of the application.
Factors we weigh up
When considering complaints about lending, we look at:
- what information the bank asked for and what information it received about the customer’s ability to repay the loan
whether the bank considered all information available to it
whether the bank complied with its own policies and procedures on credit assessment
- whether anything should have prompted the bank to seek more information
- whether the bank waived a particular policy requirement, and if so, why.
Generally we are unlikely to find in favour of a customer who was subsequently unable to service a loan if the customer:
- actively sought the loan
- was not affected by any disability at the time
- met, or almost met, the bank’s usual lending criteria, and the bank made appropriate enquiries.
We are also unlikely to find in favour of the customer if:
- the bank asked all the right questions, and they were appropriately worded
- the customer gave incomplete information about his or her financial position or gave inaccurate responses.
When we uphold lending complaints
Generally, we recommend a bank writes off some or all of the interest and charges associated with a loan if we find it has lent to someone who was unable to meet loan repayments and who benefitted from the loan (for example, by buying a property he or she wants to keep). This is because the customer should not have to bear the total cost of the borrowing.
In most cases, the customer will still be responsible for repaying the borrowed amount, and we will generally encourage the bank and customer to come to a repayment arrangement the customer can afford.
We may suggest a bank writes off a debt if there is no possibility of the customer making any repayments. In such cases, the bank may make an adverse credit listing against the customer to ensure all potential future lenders are aware the customer has previously defaulted on lending.
When we uphold refusal-to-lend complaints
We will ask a bank to reassess an application if we find that it made an administrative mistake in assessing a lending application (for example, by wrongly calculating an applicant’s income). We cannot make a bank approve a lending application because that is a matter of commercial judgement for the bank, but we do expect banks to follow an appropriate administrative process in assessing applications.
Loan-to-value ratio restrictions
Banks may decline more low-deposit home loan applications as a result of the Reserve Bank’s loan-to-value ratio restrictions. These require banks to restrict residential mortgage lending exceeding 80 per cent of a property’s value to a maximum of 10 per cent of all new mortgage lending.
For more information, see the Quick Guide on Loan-to-value restrictions. See also the Quick Guide on Guarantees. This has information for those considering guaranteeing someone else’s borrowing. The Reserve Bank website also has information about loan-to-value lending restrictions.
Transferring credit card debts
You must apply for a credit card account at the new bank if you don't have one there already. You will be assessed against the bank’s credit criteria. Check your debt before you apply to ensure it includes purchases or payments since your last statement. Note that interest accrued during the current month may not show up.
If the bank approves your application, it will pay off your card debt debit at your other bank and create a new debt. It will tell you the credit limit it is prepared to give you. The total of all transferred balances must not exceed that limit. You may be able to transfer store card or personal loan balances, but check first with the new bank about any exclusions.
You may have to close your existing credit card account if having two credit cards will exceed your debt servicing ability. Talk to your card provider. It's your responsibility as the customer to close accounts.
Interest rates on transferred balances
Transferred balances may have special low interest rates, but new purchases and cash advances are usually subject to the bank’s normal rates. Check the card’s terms and conditions to see how interest rates apply. Interest rate deals may be for a set time only. Make sure you know when that period ends and what the subsequent interest rate will be.
Allocation of repayments
Generally, your credit card repayments will be allocated to the balance with the lowest interest rate. If you have a transferred balance at a special low interest rate and you put purchases on that card, your repayments will probably be allocated to the transferred balance rather than to the recent purchases. This means any purchases or cash advances you make after the transfer won't be paid off until you have repaid the transferred balance.
Payment allocations are described in the credit card terms and conditions. Talk to your bank if you are unclear how payments will be applied. You need to continue making minimum monthly repayments and should check out potential penalty fees if you fail to make them.
Guaranteeing someone's debt
Banks will sometimes lend a customer money only if someone else provides a guarantee. If you agree to be a guarantor for a borrower, the bank can require you to pay the borrower’s debts if he or she defaults on repayments.
Note: The following is intended as a guide only. Seek independent legal advice if you are considering becoming a guarantor. If you are already a guarantor and have any concerns, contact us, the bank or your lawyer immediately. Similarly, talk to us or a lawyer if you feel you were not properly advised about a guarantee or were pressured into agreeing to it.
If asked to guarantee someone’s debts
Get independent legal advice and think carefully before agreeing to be a guarantor. The fact a bank has asked for a guarantee suggests the borrower does not meet the bank’s lending criteria, or the bank thinks the borrower may default on the loan. Ask yourself whether:
- this person can service the loan
- you know this person's credit history
- you know if he or she already has other obligations to the bank, and if so, what those obligations are
- this person is likely to let you know if her or she starts finding the repayments difficult to make
- this person is likely to tell you about any further loans he or she may take out
- you could afford to meet all of his or her obligations
- you can help this person in another way.
If already a guarantor
Your exact position will depend on the provisions of the guarantee. Most guarantees are unlimited in amount and extend to "all obligations" of the borrower. This may include all lending existing at the time you gave the guarantee, plus all of the borrower’s obligations to the bank on a continuing basis. This may include further lending, credit card debts and overdrafts. You can ask for your guarantee to be limited to a specified amount, but the bank does not have to agree to the request.
Cancelling a guarantee
In general, you can cancel a guarantee at any time. However, this does not release you from the obligations of the guarantee. It simply freezes your liability to the size of the debt at that particular point in time. The bank can require you to pay the debt that existed up to that time (including any interest and costs). If you cancel a guarantee, the bank may require the borrower to provide alternative security.
It is not uncommon for a guarantor to learn of a borrower's difficulties only when called on by the bank to cover some outstanding amount. As a rule, banks aren't obliged to notify guarantors of a borrower’s financial difficulties. In fact, banks could breach their duty of confidentiality to the borrower by doing so. The exception would be if the guarantee contained provisions – agreed to by all parties – that the bank should inform the guarantor in such a situation. The bank will, however, tell you the guaranteed debt amount at any time.
Pursuing the guarantor first
A bank has the right to call on the guarantor first if a borrower fails to make repayments. It does not have to pursue the borrower for the debt. If there is more than one guarantor, the bank can usually decide which one to pursue. It can also require only one guarantor to pay the entire guaranteed debt. In some circumstances, one guarantor may be able to pursue other guarantors for their contribution to the debt. This is not always straightforward, and we recommend taking legal advice.
A bank does not have to sell a borrower's property, over which it has a mortgage, rather than pursue a guarantor for a debt. However, a guarantor, having paid the debt, may be entitled to claim against the bank's mortgage.
Failure to pay
Most guarantees require a security from the guarantor, typically a mortgage over the guarantor's home or other property. If the guarantor cannot pay the borrower's debt, the bank can sell that property to recover its money. If the guarantee did not require a security, the bank can sue the guarantor through the courts for payment of the debt. If a guarantor has an account at the same bank as the borrower, the bank may take funds from the guarantor's account to cover the debt.
A guarantor can try to encourage the borrower to pay the outstanding amount, but invariably a bank calls on a guarantor precisely because the borrower can't pay.