Can I break my fixed-rate mortgage?

Question

I heard that people wanting to refinance their mortgage are no longer penalised with exit fees, making it easier to go elsewhere for a cheaper interest rate.

I have a $400,000 fixed-rate mortgage for three years at 7.5%pa, and interest rates are now much lower. I have one year to go before the fixed rate ends but would like to refinance to a lower rate now.

Answer

There are two separate issues here.

1. Changing mortgage lenders

All variable-rate mortgages taken out from 1 July 2011 have no exit fee.

However, if your home loan interest rate was established before this date then you may still have significant exit fees. It’s best to check with your lender how much your break fee would be before you decide to move your mortgage to another lender.

Every home loan also has a small discharge fee, typically $350 per property, to cover the cost of the lender removing the mortgage that has been registered on the title of your property. This fee is reasonable as it is an actual cost incurred by the bank.

2. Breaking a fixed-rate mortgage

Beware of breaking a fixed-rate mortgage when trying to find a cheaper lender. This cost applies regardless of when you took out your mortgage.

When your loan settled, the lender factored in a profit over three years. This profit is the difference between what they bought your funds at and the 7.5%pa they’re charging you during this time. If you exit early, they miss out on that profit, so they charge a break cost.

Break costs can also be charged when you make extra repayments on a fixed rate loan. Most lenders will allow you to pay a small amount off your loan each year without being charged, however if you go over this amount or pay off the loan entirely then you will be charged the break fee.

Banks are not very good at disclosing their break fees or how they will be calculated, so be sure to check with them before you consider refinancing.

Avoid the trap of turning your home loan into an investment loan

Question:

We have paid off most of our home loan and we want to upgrade to a new home but keep this one as an investment property.

Can we withdraw the equity in our current home and use it as a large deposit in our new home, with the added benefit of increasing the tax deductibility of the investment loan?

Answer:

No, the tax man doesn’t see it this way. You need a little foresight – well, a lot actually – to make this strategy work.

If you were to redraw some funds from your original home loan, it would be considered a new loan when it comes to tax. It’s the purpose of the redraw that determines whether the interest on that portion would be tax deductible.

In your case, using the funds as equity in a new owner-occupied home is not considered to be for investment purposes, and you could be in trouble with your taxes if you attempt this strategy.

But there is a way you can do this without being any worse off. You can get the advantages of paying down your original home loan and not get caught in this trap by having an offset account.

You could set up your home loan with a linked offset account and, over the years, rather than paying down your home loan with accelerated repayments you could instead build up savings in your offset account. Your interest bill would be the same.

The money in your offset account can provide you with a substantial deposit for your new home when you are ready to upgrade, and it allows you to maximise your interest deductibility.

You would simply withdraw the money from the offset account as all or part of your deposit on your new property and the interest on the full amount of your existing loan would be tax deductible.

Financially this could leave you in a much better position – but remember that you must act to set this up before you start paying down your original home loan.

And of course, speak to your accountant about your personal circumstances before making any decisions.

Supercharge your mortgage

If you have a mortgage then the chances are you know what it feels like to be chained to your bank.

But, did you know that an offset account can save you interest on your home and can help you pay it off sooner? It can be a truly powerful tool if used correctly.

Simply put, an offset account is a separate account that’s linked to your mortgage account, and money sitting in that account offsets the interest charged to your loan. You would need to make sure that the interest rate on your mortgage is variable as it rarely applies to fixed home loan rates.

For example, if you have a loan of $300,000 and $50,000 sitting in an offset account, then you would be charged interest on the net balance of $250,000 only.

A more attractive scenario is to have your $300,000 mortgage, plus the same sitting in an offset account. You wouldn’t be charged any interest at all in this case.

Many offset accounts act like bank accounts where you can have a cheque book, you can withdraw cash from an ATM, plus have direct debits set up to pay your bills. You can redraw any amount you want, just like a normal bank account.

And the news gets even better. Because interest on your home loan is most probably calculated daily, any funds sitting in the offset will reduce the interest charges.

A quick way of estimating your annual savings starts by estimating the average balance in your offset for a year. Let’s say it’s $10,000. If your mortgage interest rate is 6%, then your saving for the year would be $600.

$10,000 x 6% = $600

If you have a principal and interest loan, your bank may still expect you to pay the same regular instalment based on the outstanding amount in your mortgage. In this case, a greater amount of your repayment will go towards paying down the principal of your loan, helping you to pay off your home loan sooner.

A $600 interest saving means that your principal will reduce by this same amount – helping you to reach the goal of paying off your home loan sooner.

If your loan is interest only, the net amount (mortgage less offset balance) will be used to calculate the interest payable, and this will reduce as the balance in your offset increases.

Importantly, you need to understand that the effect of an offset account would be the same  as if you had put extra funds directly into your mortgage.

So why bother? The advantage of an offset account is that you can make your spare cash work harder. Rather than sitting in a bank account earning 2 per cent or less, you can make it earn the equivalent of your mortgage interest rate.

While this is great news for your own home, beware of the tax implications if you are using an offset account for an investment property. If you withdraw funds from an offset account linked to an investment property to use for personal purposes other than another investment loan, then you lose the tax deductability for that amount. This is a mistake that cannot be undone.

Of course, speak to a tax accountant for more information based on your personal circumstances.