FIXED RATE LOAN SHENANIGANS

When the day is done and you're winding down with a nice glass of red wine, do you pause to ponder the mysteries of life, like why do banks penalise fixed rate borrowers when repaying their mortgage loan early if rates have fallen, but keep the "profit" when rates have risen?

Here's the scenario. Desmond and Molly Jones (Desmond has a barrow in the market place, and Molly is a singer in a band) took out a five year Fix Rate Loan two years ago. They just won Lotto and now want to repay the loan. Here's the issue. They still have three years of their fixed rate period to go.

Will they pay a fee for doing this? Well, this depends on how interest rates have moved since they took their loan out. If interest have fallen, then the bank will incur a loss. Why?

The banks are not gamblers. They don’t cross their fingers and just hope interest rates don’t increase during your fixed rate period. They use hedging mechanisms to protect themselves, so, when the Jones' repay their fixed rate loan early, and interest rates have fallen they may need to unwind these hedges at a cost, and they can only relend those funds out at a lesser rate. Yes, they will incur loss, which the borrowers will wear. Can’t argue with that.

But, if interest rates have risen, yippee, happy days for the bank. They will benefit, ie make a profit. Will they pass this onto the Jones'. Nope.

You will find the formula they use to determine the “Break Cost” in your loan contract. In essence, it is based on the current loan balance, the remaining fixed rate term and the difference in wholesale interest rates, with actuaries fiddling with it to consider things like Net Present Values.

When relevant data is entered into their calculator, a positive or negative figure (loss or profit) is revealed. You know what happens don’t you? The loss is passed onto the borrower; however, the profit is held by the bank to fund their Christmas party.

It was not always so. A bank I worked for in the 90’s did in fact pass such profits to borrowers, but that bank no longer exists.