Key Post Understanding Fixed Rates breakage costs

Discussion in 'Mortgages and buying and selling homes' started by RedOnion, 22 Jul 2017.

  1. RedOnion

    RedOnion Frequent Poster

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    Last edited by a moderator: 5 Sep 2018

    Understanding Fixed Rate breakage costs

    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.

    If the rates at which banks lend to each other have fallen since you fixed, then there will be a breakage fee.

    If the rates at which banks lend to each other have risen, there should be no breakage fee.

    As of now, July 2017, the rates at which banks lend to each other is close to zero, so they are expected to rise.

    So if you fix now, there should be no breakage fee if you want to break at some stage in the future - unless interest rates fall further.


    Summary:

    When you seek to break a fixed rate mortgage early, the breakage cost can't be more than the difference between the rate the bank was able to borrow money at for the original term in the inter-bank markets, minus what they can get for depositing the money in the inter-bank markets for the remaining term, times the remaining term.

    If you are paying off a lump-sum, rather than the entire balance, the breakage fee is only calculated on the lump sum amount.

    Breakage fees are calculated on inter-bank market rates, so are independent of any pricing decisions a bank makes in setting rates charged to customers.

    More details below, with worked examples using theoretical scenarios.

    Fixed Mortgage Rates - what if variable rates go down?
    We probably all remember (or may even have experienced ourselves) quotes of 10K and more for people to break mortgages when rates fell in the past, particularly when rates fell rapidly after the initial reaction to the financial crisis in 2009. It's a memory that frightens many people away from fixing their mortgages.

    However, those large break costs were the result of 2 factors:
    1. Actual market rates (bank funding costs) were coming down, and it cost banks money to break their fixed hedging early, and
    2. There was a bit of 'wiggle room' in how banks calculated breakage costs.

    Calculating Breakage costs
    Prior to 2016, fixed rate lending was covered by the 1995 Consumer Credit Act. There were various ways in which a bank could propose to calculate fixed rate breakage fees, although all methods had to be approved by the Central Bank.

    Since 2016, the calculation is governed by the 'European Union (Consumer Mortgage Credit Agreements) Regulations 2016' http://www.irishstatutebook.ie/eli/2016/si/142/made/en/print
    The regulation doesn't specify exactly how the breakage is to be calculated, it is quiet specific that the cost to the consumer should not exceed the financial loss to the bank. A bank must provide a written breakage quote to the consumer, and list all assumptions used. All assumptions must be reasonable, and justified.

    What this boils down to is that the breakage cost can't be more than the difference between what the bank was able to borrow money for for the original term in the inter-bank markets, minus what they can get for depositing the money in the inter-bank markets for the remaining term, times the remaining term.

    If market rates remain as they are now, to break a 2 year rate taken now in 1 year's time would cost approx 0.2% of the balance.

    In the case of a rising interest rate market, the resulting breakage could be Nil.

    Taking a fixed rate mortgage is really taking a view on the wholesale interest market for the next few years. I would argue that staying on a variable rate is also taking a view, as you're betting rates will either stay the same, or fall.


    Some worked Examples:

    Example 1 - I fix and I break immediately

    I fix my rate with Bank of Ireland today for 2 years at 3.2%.
    I decide 1 month later that I want to switch to EBS to get the 2% cash back from them.
    The rate BoI borrowed from the market last month, and the rate they can get for lending to the market today is the same, so there might be a marginal breakage cost.
    (In this case there might be a marginal breakage cost, as there are dealing costs in settling fixed rate contracts)


    Example 2 - The rates at which banks lend to each other fall
    I borrow €100,000
    I fix my rate with Bank of Ireland today for 2 years at 3.2%. BoI's funding rate in the market is 0%.
    After one year, I decide I want to switch to another lender.
    The one year inter-bank Market rate is now -0.4% in the market.
    Bank of Ireland can relend to the market at -0.4% instead of the 0% they borrowed at so the breakage fee is
    €100,000@ 0.4% x 1 year = €400


    Example 3 - rates rise

    I borrow €100,000
    I fix my rate with Bank of Ireland today for 2 years at 3.2%. BoI's funding rate in the market is 0%.
    After one year, I decide I want to switch to another lender.
    The one year interbank rate is now +0.25%.
    Bank of Ireland can relend at +0.25% instead of the 0% they originally borrowed for, so there is no cost to them, so there is no breakage fee to the customer.


    A real life example

    Take a look at this post for a real example of a breakage calculation

    Examples of the cost of breaking a fixed rate early
     
    Last edited by a moderator: 5 Sep 2018
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  2. RedOnion

    RedOnion Frequent Poster

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    Last edited: 26 Jul 2017
    Note, if you are an AIB customer, it appears that they are interpreting the legislation differently from the other lenders and if you are quoted a high cost, it may be worth challenging.

    Dilosk and other non-bank lenders may have higher breakage fees because their funding models are different. Again, worth challenging as the break cost cannot be more than the actual cost to the lender.
     
    Last edited: 26 Jul 2017
  3. Sarenco

    Sarenco Frequent Poster

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    Good post Red Onion - that all looks right to me and your key point is well made.

    It might be worth noting that BOI have been very open about the fact that they are deliberately incentivising customers to fix as they take the view that the current interest rate environment is abnormal. As such, the discounted fixed rates (relative to variable rates) that we are currently seeing may not be reflective of a dysfunctional market but rather a view on the future trajectory of interest rates and the impact that might have on default rates.
     
  4. Brendan Burgess

    Brendan Burgess Founder

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    Hi Red

    I have re-read this and edited it to make it much simpler to understand, I hope.

    I have suggested new bits in red.

    I suggest deleting the stuff which I have reduced in font size. It may be interesting but it makes the post too long and too complicated.

    I have edited your second post to make some specific points.

    Brendan
     
  5. Brendan Burgess

    Brendan Burgess Founder

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    Hi Red

    Am I right in saying:

    Up to 2016, banks could set the breakage cost, more or less, at their own discretion.

    Since 2016, the rules have changed. As inter-bank rates have fallen over the past few years, there will be a break cost, but it is likely to be smaller than what it would have been had this legislation not been introduced.

    Brendan
     
  6. RedOnion

    RedOnion Frequent Poster

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    Last edited: 25 Jul 2017
    Hi,

    Prior to 2016 the breakage costs were covered by the consumer credit act. In summary each bank could come up with a calculation, which had to be approved by CBI. There were different variables, some of which were linked to bank pricing policy rather than external market rates.

    The big break costs in 2009 were largely due to rapidly falling interbank rates, but they were difficult to challenge.

    Under new regulations it's an offence for a bank to add anything to their actual break costs.

    I'm not sure if the regulation applies to fixed rates entered into before it was enacted.

    R.
     
    Last edited: 25 Jul 2017
  7. RedOnion

    RedOnion Frequent Poster

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    Rates have been relatively stable since around march 2016. However the 1 year rate is still less than the 2 year rate, so even if rates remain completely unchanged, there would still be a break cost for exiting a 2 year rate after 1 year. But it'd only be about 20bps of the balance.
     
  8. Brendan Burgess

    Brendan Burgess Founder

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    Last edited: 25 Jul 2017
    Hi Red

    Are these the sections of the Act which cover it?

    My summary of this in plain English


    A lender shall be entitled to charge a fair and objective break fee, where justified, for possible costs directly linked to the early repayment of a fixed rate mortgage.

    Any such break fee shall not exceed the financial loss of the creditor.

    A lender shall not be entitled to impose a sanction on the borrower for early repayment of a fixed rate mortgage

    The actual act

    Early repayment



    26. (1) A consumer has a right to discharge fully or partially his or her obligations under a credit agreement prior to the expiry of that agreement. In such cases, the consumer shall be entitled to a reduction in the total cost of the credit to the consumer, such reduction consisting of the interest and the costs for the remaining duration of the contract.



    (2) A creditor shall be entitled to fair and objective compensation, where justified, for possible costs directly linked to the early repayment, but shall not impose a sanction on the consumer, and any such compensation shall not exceed the financial loss of the creditor.



    (3) Notwithstanding paragraph (2) and without prejudice to paragraph (4), a creditor’s entitlement to compensation under this Regulation shall arise only in the circumstances where the borrowing rate provided for in the credit agreement:-



    (a) may not be changed, or



    (b) may not be changed over a period of at least one year, or



    (c) may not, for a period of at least five years, exceed the rate applicable on the date of the making of the credit agreement by more than two percent.
     
    Last edited: 25 Jul 2017
  9. RedOnion

    RedOnion Frequent Poster

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    Yes that's a good summary.
    I'd add in the section re providing a written quote, with assumptions, without delay.
     
  10. Brendan Burgess

    Brendan Burgess Founder

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    There is nothing in the Act to say "These regulations apply only to mortgages issued after x/x. 2016" so it applies to all mortgages.
     
  11. Brendan Burgess

    Brendan Burgess Founder

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    Ah, that is a point I missed.

    When I took out my mortgage 5 years ago, the rate for 5 year inter-bank lending was 5%, say and the rate for two year lending was 3%.
    Today with two years to go, the rate for two year lending is still 3%.

    So although rates have not fallen, the shorter period means that the lender has a loss in re-lending the money as the rate for two years is lower than the rate for 5 years.

    Brendan
     
  12. RedOnion

    RedOnion Frequent Poster

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    Yes, you've put it better than I did.
     
  13. Brendan Burgess

    Brendan Burgess Founder

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    Hi Red

    Is there anything published on the interpretation of this?

    Has the Central Bank issued any guidelines? Has the CPPC issued any guidelines?

    Have the banks published their interpretations?

    Brendan
     
  14. Brendan Burgess

    Brendan Burgess Founder

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    Last edited: 26 Jul 2017
    Ulster Bank explains it as follows. There appears to be a bit left out which I have guessed at [in green] and highlighted the bit in the example in red.

    Early Redemption Charge
    If you pay off a fixed rate mortgage before the end of the agreed fixed period or change to another interest rate before the end of the agreed fixed rate period, an early redemption charge will be applied. This charge will be either [6 months' interest] or an amount calculated using this formula, whichever is lower:
    Redeemed amount x (R - R1) x Time remaining in days until the end of the fixed rate period) divided by 360.

    In this formula:
    Redeemed amount means the estimated average loan balance between the time of the proposed repayment or interest rate conversion and the end of the relevant fixed rate period, assuming that no such repayment or interest rate conversion takes place and that all scheduled repayments of the loan are made by the borrower under the terms specified in the loan offer. Where a lump sum repayment is made, redeemed amount shall mean the amount of the lump sum repayment.

    R means the interest rate available to the lender for funds placed in the money market on the start date of the relevant fixed rate period for the duration of the relevant fixed rate period.

    R1 means the interest rate available to the lender for funds placed in the money market on the date of the proposed early repayment, lump sum repayment or interest rate conversion for the remainder of the relevant fixed rate period. The rate applied is based on the remaining fixed rate term of the mortgage, rounded to the nearest month if less than one year or to the nearest year if greater than one year.

    Time means the number of days from the date of early repayment, lump sum repayment or interest rate conversion to the end of the relevant fixed rate period.

    Six months interest is the estimated interest that would be payable in the six months following the proposed repayment or interest rate conversion.

    Typical Example

    In the example below, a customer took out a 5 year fixed mortgage at a rate of 5.00% on 1st January 2014. On 4th January 2015, the mortgage outstanding was €100,000 and the customer opts to break out of the fixed rate. The breakage cost calculation is:

    Redeemed Amount = €87,832.42
    R (Market rate on 1st January 2014) = 2.849% (for a 5 year interbank deposit by Ulster Bank)
    R1 (Market rate on 4th January 2015) = 1.713% (for a 4 year interbank deposit by Ulster Bank)
    Time = 1,457 days
    Breakage Calculation = (Redeemed Amount x (R-R1) x Time) divided by 360 = (€87,832.42 x (2.849% - 1.713%) x 1,457)/360 = €4,038.22
    Six Months Interest = €2,500
    Therefore, in this case the customer would be charged the lesser amount of the six months interest i.e. €2,500.

    When your fixed rate mortgage expires you can revert to the Standard Variable Rate or any other mortgage product that you may be offered at this time. As Standard Variable Rate is not linked to the European Central Bank base rate (ECB), the rate can increase at any time even if there is no change in the ECB base rate.
     
    Last edited: 26 Jul 2017
  15. RedOnion

    RedOnion Frequent Poster

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    I'm not aware of any CCPC / CBI guidance on this.

    I never thought to look at UBs wording, but strictly speaking it's a more technically correct interpretation than in my OP (I'll update).

    If Dilosk applied the same definition of R1, they'd be fine, and in the example of @Moon light in another thread, the breakage cost would be c. 80% lower.
     
  16. RedOnion

    RedOnion Frequent Poster

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    A question that pops up in a few threads discussing fixed rate mortgages is whether or not you can overpay during the fixed rate term before the bank check if a break fee is payable.

    From what I can gather each of the banks rules are as follows (any corrections welcome).
    I have based this on each Banks Terms & Conditions. I won't comment on whether the banks system / processes can be circumvented:

    AIB: No early repayments allowed without checking break fee
    Bank of Ireland: The greater of EUR65 or 10% of normal repayment each month. However, this is done by increasing monthly repayment, and can’t be paid in as a lump sum.
    EBS: No early repayments allowed without checking break fee
    KBC: 10% of the initial balance can be repaid early at any stage during the term without incurring a break fee. This is a cumulative limit of the fixed term
    PTSB: No early repayments allowed without checking break fee
    Ulster Bank: 10% of the balance at the beginning of each year can be repaid (each year) without incurring a break fee
     
  17. RedOnion

    RedOnion Frequent Poster

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    Last edited: 23 Mar 2018
    I have included below a summary of the fixed breakage fees in place across all the major mortgage providers in Ireland (wording paraphrased in some cases).

    As mentioned in an earlier post, AIB base their break costs on the difference between your fixed rate, and their fixed rate currently applicable for the remaining period.

    ALL the other banks base break costs on market rates of some description - whether cost of funds, deposit rate available, or interbank SWAP rates.

    BankR1R2Source
    AIBthe fixed interest rate applicable at the start of the fixed interest periodthe fixed interest rate applicable as at date of premature payment/conversion, for the unexpired fixed interest rate periodhttps://aib.ie/our-products/mortgages/Home-Mortgages-Regulatory-Information
    Havenoriginal cost of funds – The cost of funds for Haven for the fixed rate period at the time the fixed rate period commenced.cost of funds for the fixed rate period remaining – Fixed rate period. The cost of funds used will be as of 5pm the day previous to the request to calculate the early redemption charge.https://www.havenmortgages.ie/useful-information/regulatory-information#false
    EBSoriginal cost of funds - The cost of funds for EBS for the fixed rate period at the time the fixed rate period commenced.cost of funds for the fixed rate period remaining - Fixed rate period. The cost of funds used will be as of 5pm the day previous to the request to calculate the early redemption charge.https://www.ebs.ie/mortgages/home-mortgages-regulatory-information
    BOIthe annual percentage interest rate which was the cost to us of funding an amount equal to “A” for the originally intended fixed rate periodthe annual percentage interest rate available to us for a deposit of an amount equal to “A” for a period equal to “D”https://personalbanking.bankofireland.com/borrow/mortgages/information-and-legal-notices/
    KBCThe Fixing Rate prevailing at the date of the existing fixed rate applying to the loan was set (Fixing rate is Cost of Funds)The Fixing Rate prevailing at the switching/redemption date for the unexpired time period of the Fixed Rate Period (Fixing rate is Cost of Funds)https://www.kbc.ie/KBC/media/Mortgages-PDFs/Mortgage-App-Form-Existing-Customer-28042017.PDF
    PTSB“I” is the swap/market fixed interest rate for the term of the Fixed Rate Period at the date of its commencement“S” is the swap/market interest rate for the remaining fixed period,https://www.permanenttsb.ie/globala...tsb-personal-and-business-banking-charges.pdf
    Ulster Bankmeans the interest rate available to the lender for funds placed in the money market on the start date of the relevant fixed rate period for the duration of the relevant fixed rate periodmeans the interest rate available to the lender for funds placed in the money market on the date of the proposed early repayment, lump sum repayment or interest rate conversion for the remainder of the relevant fixed rate period.http://digital.ulsterbank.ie/personal/mortgages/fixed-rate-mortgages.html
     
    Last edited: 23 Mar 2018
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  18. Angelblue1978

    Angelblue1978 Registered User

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    Hi

    I wonder can anyone assist me here with these calculatiosn received from Haven.
    I borrowed €378,000 in September 2015 @ 3.8% fixed rate for 5 years. 6/7/2017 I repaid the mortgage and paid a Early Breakage fee of €3088.61. Can you please tell me what the interbank rates were on these specific dates and whether this calculation is correct.

    Many thanks

    A
     
  19. sojourn2015

    sojourn2015 Registered User

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    I would also need assistance if anyone can help me with my calculations as the bank refuse to show me how they calculated the penalty figure of 27,000.00 apart from sending me an indecipherable formula. I should just take their word they are correct! I borrowed approx 425,000.00 on a 10 year fixed rate in June 2008 @ 5.44% - the interest was around 1,800.00 per month. I paid off the mortgage in December 2016. In total I paid 563,000 - capital, interest, arrears and the breakage fee. Unfortunately, I had no choice but to sell my home or it would have been repossessed. EBS is the financial lender. While I realized I had no choice but to sell, and co-operated with the bank, I did take them to task over the enormous breakage fee, but to no avail.
     
  20. RedOnion

    RedOnion Frequent Poster

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    Hi @sojourn2015
    Do you know what the principal balance was when you repaid?