Fixed vs variable: backing the right horse

If you had locked into a fixed term loan a couple of years back, you would be feeling pretty smug right now after 7 rate rises since 2006.

While you are clearly better off than many Australians with your sub-seven-percent loan, at the time you still took a punt on interest rates and could have found yourself paying over the odds had rates actually gone down.

Fixed term loans are just that. They give you the security of a regular repayment amount but they are meant to be for the fixed term.

So what if you wanted to get out of your current home loan? For instance, maybe you have just won the lottery and want to clear your debt. Do you have to pay any penalties for getting out of the loan sooner?

Fixed term loans usually charge an early termination fee or break cost plus an administration fee if you pay the loan out earlier than the agreed fixed period.

But if rates in general have gone up during the course of your loan, then at most you should only be hit with the administration fee and in some cases your lender might pay you for breaking the term!

This is because the lender is better off having you close the loan so they can lend the money to somebody else at a higher rate.

According to a pamphlet from BankWest, the early termination fee basically covers the difference between the bank's funding rate (borrowing swap rate) for the agreed fixed term at the time you took out the loan and the rate the bank is guaranteed to earn over the period remaining of the original fixed term (investing swap rate) at the time your loan is paid in full.

"If you pay out the loan early and the rate that the bank is guaranteed to earn is higher than the original funding rate, you may receive a benefit," says the pamphlet.

So for simplicity's sake, if you took out the loan when rates were 6.5 percent and they were now eight percent and you still had two years left on a five-year loan with a current loan principal of $100,000 then you could end up with $3000 in a benefit.

Calculations can change on a daily basis due to constant changes in money market interest rates.

ANZ Bank also says that in an environment of rising interest rates where fixed rates are increasing it is unlikely to charge an early repayment cost.

It is understood that some non-bank lenders who use brokers to sell their products may still charge some sort of break fee as they have already paid the brokers upfront.

But if your loan is directly with the lending institution then in most cases you should receive some benefit for giving them the opportunity to lend the money at a higher rate.

Denis Orrock of financial products researcher Infochoice says that while lenders should be giving money back to those who break their fixed term loan, it is quite understandable for them to be charging an administration fee.

Generally this fee is around the $300 mark.

Of course unless you can afford to pay the loan out in full there would be no point in undertaking the exercise as you would have to refinance and this would almost definitely be at a higher rate.

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