Key Post How to evaluate if it's worth breaking out of a fixed rate

[Zenith63]

Moderator's note: This is an important calculation and many people make the following mistake:

KBC came back with a break-fee of €1305. This is a 3 year 2.99% fixed-term with 24 months left on €416k. I'd save €2016 over 2 years by going onto the newer 2.6% 3 year fixed against a cost of €1305+€127 valuation fee, so €584 net.

 

[Brendan Burgess]

Hi Zenith

Look at the interest charged and not the repayments.

The reduction in interest is 0.39% (2.99% - 2.6%)
So the annual savings in interest are €416k @0.39% or €1,600
The savings over two years are €3,200

As the savings exceed the break-fee of €1,305, then it is worth breaking and re-fixing

Brendan

 

[RedOnion]

Correct, at a lower interest rate you repay capital faster, so the extra 1200 is reducing your balance.

 

[Brendan Burgess]

Other factors to consider:

1) Don't break until you are sure you are able to avail of the lower rate

• For example, KBC's new lower fixed rates are not available until 3rd September 2018, so don't break until then
  
• If you are switching to a new lender, it probably won't make sense to break out of the fixed rate until the switch goes through. It could take up to three months for the legal work to be done.

2) If you are relying on a revised valuation of your home, get the valuation first so that you know what your Loan to Value will be

3) While you are at it - is it worth paying down some capital to bring you into a lower LTV category? For example:

House value: €200k
Mortgage €121k
Loan to value: 60.5%

If you reduce your mortgage balance to €119k by paying €2k capital

House value: €200k
Mortgage €119k
Loan to value: 59.5%

Rate will be 2.6% instead of 2.65% giving an annual saving of 0.05% or €60

 

[Zenith63]

Thanks for the responses guys, really helpful!

Can you help flesh out why you look at interest and not repayments though, asking for a friend who is struggling to get his head around it .

If the term is not going to change, then surely if I've got 348 out of 360 payments left to make, if I reduce my monthly payments by say €84 then the "saving" is just 348x€84=€29232? But in this case I'm just thinking about the next two years so it's two years worth of that same saving, or €2016? I thought this was the point of the constant period payment calcs they do.

Or is your thought process here that if you decided to pay off the mortgage early at some point in the future, then you'd have paid down more of the capital on the lower interest rate and see the saving then?

 

[Brendan Burgess]

Hi Zenith

It's quite hard to explain - so please do take our word for it.

If you want to study it, you will find the background here: A Guide to Mortgage Repayment Calculations.

As Red points out - after two years
1) You will have paid €2016 less in repayments, and,
2) Your balance will be €1,200 lower than it would otherwise have been.

So you will be €3,200 better off. Always look at the interest calculation and never at the repayments.

Brendan

 

[RedOnion]

Say your example of balance of 416k.
Assuming 20 year term.

At 2.99%, at the end of 2 years, remaining balance is 384,667
At 2.6% it would be 383,400

That's 1200 less that you don't have to repay in future. Ok, it's not a huge amount monthly, but it's a reduction in your balance.

You've saved over 3200 in 2 years, but see the benefit over 20 years.

 

[Andrew365]

@RedOnion Can I use the Euribor 1m as the market rate? I have used Euribor 1m of -0.42% (Fixing) and -0.51% current level of Euribor, 16 months left and principal of 455k, results in break of 551. If it is the case, I can time the break, for example today the rate is higher than yesterday, however it would not have a large impact.


B = (W - M) x T / 12 x A, where:
B = The Break Funding Fee.
W = The Wholesale Rate Prevailing at the date of the existing fixed rate applying to the loan was set.
M = The Wholesale Rate prevailing at the switching/redemption date for the unexpired time period of the Fixed Rate Period.
T = Period of Time in months to the end of the Fixed Rate Period.
A = Principal amount which is subject to the existing fixed rate and which is being switched or redeemed.

 

[RedOnion]

Hi @Andrew365
No, you'll need to use the appropriate term rate. So if you fixed for 4 years on 29th Jan 2019, you need to use the difference between the 4 year rate then (W) and the 3 year rate now (M)

I use the ice swap rates as a very close estimate of the rates banks use. I've replicated a number if break fees to within a euro, so it's accurate enough.

ICE Report Center - Data

www.theice.com

Which bank are you with?

 

[Andrew365]

Hi @Andrew365
No, you'll need to use the appropriate term rate. So if you fixed for 4 years on 29th Jan 2019, you need to use the difference between the 4 year rate then (W) and the 3 year rate now (M)

I use the ice swap rates as a very close estimate of the rates banks use. I've replicated a number if break fees to within a euro, so it's accurate enough.

ICE Report Center - Data

www.theice.com

Which bank are you with?

Interesting as banks borrow at Euribor 1M or 3M, 6M, then swap rates come into play. I was looking at the 1M EURIBOR on the day I took out the mortgage vs the rate today. I am with KBC, that is their equation posted above, I took out a 2 year fixed in May 2019 at 2.6%, considering breaking to get their 2.3% rate.

 

[RedOnion]

@Andrew365
If a bank is lending at a fixed rate, they'll have swapped back to 3M usually. If not they're carrying an interest rate risk. Part of what caused the collapse of Northern Rock in the UK. Have a look at any annual report for a bank, and they'll have a disclosure on their hedging derivatives volumes.

The break fee is exactly what it'd be to break an interest rate swap if you're familiar with that market?

 

[RedOnion]

@Andrew365
It's probably explained better in the following thread:

Key Post - Understanding Fixed Rates breakage costs

Understanding Fixed Rate breakage costs (Updated May 2019) Summary The manner in which lenders calculate their breakage costs is set down under new legislation introduced in 2016. The interest rates charged by the lender to their customers are not relevant. As of now, May 2019, the rates at...

www.askaboutmoney.com

 

[Andrew365]

@Andrew365
If a bank is lending at a fixed rate, they'll have swapped back to 3M usually. If not they're carrying an interest rate risk. Part of what caused the collapse of Northern Rock in the UK. Have a look at any annual report for a bank, and they'll have a disclosure on their hedging derivatives volumes.

The break fee is exactly what it'd be to break an interest rate swap if you're familiar with that market?

yes makes sense that fixed vs float swaps are generally against the 3m / 6m. The rates < 1y largely move in tandem so my calc based on 1m should largely be accurate. Thanks for the input.

 

[RedOnion]

so my calc based on 1m should largely be accurate

I don't think so?
The difference between the 2Y rate in May 2019, and the 1Y rate now, is greater than the movement in the 1M rate between the same dates.

 

[Andrew365]

I don't think so?
The difference between the 2Y rate in May 2019, and the 1Y rate now, is greater than the movement in the 1M rate between the same dates.

What would you estimate? KBC equation is the difference between rates, as I did the calc on the 1m, I was assuming the difference would remain largely the same for short dates as the curve is not inverted.

Admittedly I have not thought about a banks mortgage interest rate hedging strategy. I assume there will be an optimal hedge ration factoring the cost of hedging.

 

[RedOnion]

What would you estimate?

I reckon your (M-W) should be 16bps.
Using 1M it'd only be 9bps

Rough estimate