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Early repayment costs on fixed rate loans

28 Nov 2014

Many banks enable customers to make small additional home loan repayments without penalty.

However, a bank or other lender may charge you an early repayment cost (ERC) fee if you repay a fixed interest rate loan or make a significant lump sum payment before the fixed rate term ends. Early repayment costs are also commonly known as break fees. 

 

Why do lenders charge ERCs?

Often when a fixed rate loan is repaid early, the lender will lose money. It recovers this loss through the early repayment cost.

Broadly speaking, a lender will lose money if interest rates at the time of early repayment are lower than the interest rate applicable to the loan.  This is because the lender cannot re-lend the repaid funds at the same rate that it could when it first loaned the money. Calculating an ERC involves a complex formula.

If interest rates have remained stable or have risen, there will not be a cost to the lender if the loan is repaid early, and they won’t charge an ERC.

A lender may charge an administration fee when a loan is repaid, regardless of whether an ERC is payable. Such a fee is usually a flat fee for the administrative costs involved in processing the repayment of the loan. This is separate from an ERC.

 

Are lenders allowed to charge ERCs?

Yes.  Lenders are entitled to require you to cover any costs that result from a loan being repaid early.  But this must be set out in the terms and conditions of your loan contract.

For consumer credit contracts (such as personal loans and mortgages), how much a lender can charge is regulated by the Credit Contracts and Consumer Finance Act (CCCF Act).

The Act says a borrower may repay a loan at any time and the lender may, if set out in the loan contract, charge the borrower for any costs that result from early repayment of the loan.  The charge must be a reasonable estimate of the actual cost to the lender of the loan being paid back early.

The Commerce Commission investigated ERCs in 2009/10. It concluded the various calculations used by lenders were likely to produce a reasonable ERC, and complied with the CCCF Act.

 

Can my lender tell me how much the ERC will be when I take out the loan?

No.  When you enter into a fixed interest rate loan, a lender can’t know whether it will lose money if you repay your loan early. Whether it loses money, and how much the loss might be, will depend in part on interest rates at the time of early repayment, as well as how early you repay the loan.

However, the lender must set out in the contract that an ERC may be charged if you repay your loan early, and how the ERC will be calculated.

 

Is it possible to negotiate with a lender over an ERC?

As lenders are only allowed to recoup the reasonable costs they may incur when a fixed rate contract is broken, they are generally reluctant to reduce or waive ERC.  However, it is always open to a borrower to try to negotiate a favourable deal with a lender.  It is possible this could include an agreement about how or whether ERC is to be applied in a particular case.  Any such agreement is within the lender’s discretion in the same way as an offer to meet legal or valuation costs or a reduction in the interest rate may be negotiated.  It is a lender’s decision whether or not it is prepared to negotiate with the borrower.

 

What can I do if I have an issue with an ERC my lender has charged me?

In times of falling interest rates, ERCs can rise significantly. Customers can be surprised at the size of the ERC payable in the event they repay their loan early.

If you have a problem relating to an ERC charged by your lender that you have been unable to resolve directly with it, you can contact us.  Before you do, bear in mind simply charging an ERC is not necessarily an issue in itself.

The types of things that could be a concern are if:

  • your lender didn’t tell you about the ERC
  • your lender didn’t tell you about how the ERC is calculated
  • the ERC has not been charged according to the loan contract.  In other words, there has been a mistake in the calculation
  • you were told something incorrect about the ERC, eg, when, why or how an ERC would be charged
  • your lender gave you incorrect advice about the most appropriate type of loan for your circumstances.  For example, if you sought advice from your lender and said you intended to sell your property within a specific time period, a recommendation to fix the interest rate beyond that period may not be appropriate.

We refer any complaints about the methodology used by a lender to calculate the ERC to the Commerce Commission. The Commission enforces the CCCF Act and has greater powers to deal with lenders that may have breached it.

 

Case note 1

Mr G and his partner Ms L approached their bank about fixed rate home loans and were given the current rates and advised that if they broke the contract before the fixed term ended they could be charged an early repayment cost (ERC). Mr G and Ms L later decided to take the fixed rate loan, and when they signed the documents were again advised about the ERC but they did not make any further enquiries.

Some months later Mr G and Ms L decided to take advantage of falling interest rates by breaking their fixed rate loan and reverting to a floating interest rate. They were unhappy to discover the ERC was several thousand dollars. They complained to us that the bank had not given them sufficient warning of the likely cost of early repayment, and had they understood they may not have entered into the fixed rate contract. They wanted the bank to reduce or waive the ERC.

We found the bank had met it obligations when it drew the couple’s attention to the possibility of a charge if the fixed rate contract was broken early. We did not accept their argument that the bank should have warned the cost could be substantial. There is no way to establish in advance whether an ERC will be incurred or its amount.

Mr G and Ms L remained unhappy about the ERC and did not accept our view.  As there was nothing more we could do, we recommended Mr G and Ms L withdraw their complaint.

 

Case note 2

Mr L wanted to refinance his mortgage with another bank. He had a fixed rate loan and realised he might have to pay an ERC.

Mr L asked the bank for an estimate of what he would have to pay, and he was given a quote of approximately $8,000. However, the bank calculated the estimated ERC incorrectly. When Mr L broke his loan six weeks later, he was charged $17,000 in break fees.

The bank offered Mr L $750 as compensation for stress and inconvenience. It considered that, although the quoted break cost had been incorrect, because an ERC quote is only valid for a very short time (typically a matter of days), the quote was invalid in any event. The bank said Mr L should have sought a further quote before breaking the loan. Mr L wasn’t happy with the bank’s response and complained to us.

Our office determined that Mr L had not been made aware the quote was applicable for only a short period of time. Mr L had also asked the bank officer if the quote was still the same on numerous occasions in the weeks before his loan was refinanced. Each time the bank officer reconfirmed the original quote.

The bank reviewed Mr L’s case based on this new information, and offered to refund Mr L $8,600 and make a goodwill payment of $500 to recognise stress and inconvenience caused. Mr L accepted the bank’s offer.  

 

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