Mortgages: The Cost of Terminating Ahead of Schedule

Fixed rate mortgages provide a welcome escape when interest rates begin to show signs of increasing. But when rates drop, fixed rate mortgage users often feel cheated by the rates they subscribed to earlier on.

Home owners taking out fixed rate mortgages with terms longer than one year are often interested in knowing whether or not they can refinance using a cheaper mortgage if their original mortgage becomes a bad deal.

In the unfortunate event of illness, disability, divorce or bankruptcy preventing mortgagors from meeting their mortgage obligations, an early termination may be the only option.

Penalty fees for early termination

A fixed rate mortgage is a contract which guarantees you a fixed interest rate on a home loan during a predefined mortgage term. Withdrawing from this agreement ahead of the agreed mortgage term normally involves paying a penalty fee for breaking the contract. The same rule applies – to a lesser extent – to fixed LIBOR-based mortgages.

The opposite scenario – in which a mortgagor chooses to terminate a fixed rate mortgage when average mortgage rates increase and surpass the interest rate which they pay – is less common. In this case the lender may compensate the borrower if the mortgage agreement includes a compensation clause.

In both scenarios, the terms and conditions laid out in the mortgage agreement are the deciding factor in determining the cost of early termination. Carefully reviewing a mortgage agreement before signing is important. If you have question about penalty fees, ask the lender to explain the logic behind their penalty fee calculations.

Early termination compensation

Penalty fees are usually high, and can make terminating your mortgage an unattractive option even when interest rates are low. The penalty you pay depends on your mortgage’s interest rate and the remaining fixed rate mortgage term.

The lender calculates exactly how much they would earn of a fixed rate mortgage in interest payment across the full term. When you terminate your mortgage early, you must pay the sum of all remaining interest payments so that the lender makes the profit stipulated by the contract.

Because the lender recovers the full amount of money owed when you pay the debt ahead of schedule, they can reinvest that money immediately and earn returns. These hypothetical returns are deducted from the amount you owe.

After hypothetical returns for the lender have been deducted from total interest owed, administrative fees are added. These fees vary between banks. The total penalty fee you pay for terminating your mortgage can add up to tens of thousands or – in the case of large mortgages – even hundreds of thousands of francs.

Example: A home owner mortgaged their home for 500,000 Swiss francs using an 8-year fixed rate mortgage. The mortgage has an interest rate of 3% per year They decide to terminate the mortgage 2 years before their fixed rate mortgage term expires. The hypothetical returns which the lender could earn on remaining money owed come to 1% per year. This is deducted from the 3% interest owed each year, so the penalty fee comes to 2% per year – or a total of 20,000 francs for the remaining mortgage term.

The early termination mortgage calculator makes it easy to find out how much you can expect to pay in penalty fees if you were to terminate your mortgage ahead of schedule.

Penalty fees when interest rates are negative

Early terminations can be even more complex in a negative interest rate environment. Some Swiss banks like PostFinance and the Zürcher Kantonalbank are of the opinion that a negative return should be added to penalty fees – instead of a positive return being deducted. The logic behind this is that when mortgagors return money owed to the lender ahead of schedule, the lender must pay negative interest on that money instead of earning interest on it. Many Swiss banks do not add or subtract positive or negative returns, but simply use a 0% return rate.

Example: A home owner mortgaged their home for 500,000 Swiss francs using an 8-year fixed rate mortgage in a negative interest rate environment. The mortgage has an interest rate of 3% per year They decide to terminate the mortgage 2 years before their fixed rate mortgage term expires. The hypothetical returns which the lender could earn on remaining money owed come to -0.7% per year. This extra 3500 francs per year (-0.7%) is added to the 15,000 francs owed each year (3% interest), so the penalty fee comes to 3.7% per year – or a total of 37,000 francs for the remaining mortgage term.

In practice, passing on negative return rates to mortgagors is highly debated, and the idea probably would not stand up in a court of law. The lender is free to invest the money in income-generating ventures instead of paying negative interest to place it in the Swiss National Bank.

When is early mortgage termination worth it?

If you can save more money by refinancing your mortgage than you would pay in penalty fees, terminating ahead of schedule makes sense. To determine potential savings, you first need to calculate the difference between the interest you would pay for your current mortgage and the interest you would pay for a new mortgage. Once you know how much you can save in interest charges, subtract the total penalty fee from that amount. Make sure to account for the fact that penalty fees are tax deductible in many cantons.

If you expect interest rates to rise in the future, make sure to account for the total amount you can save by refinancing to a cheaper fixed rate mortgage – including savings beyond your current mortgage term.

As a rule of thumb, terminating a mortgage early can pay off if the difference between your current mortgage rate and the going market rate is at least 1.5% and you have a remaining mortgage term of at least 1 year.

You can find out exactly how much you can expect to pay and whether or not early termination makes sense based on your situation using the early termination calculator on moneyland.ch.

Ask for an early termination quote

A good first step is to ask your bank to let you know what the exact penalty fee would be in your case. Note that it may be possible to negotiate the penalty fee, particularly if you are refinancing your mortgage with a new loan from the same lender. You can also negotiate the interest rate for your new mortgage. Make sure to get a quote from your lender.

If you feel that the penalty fee is unjustifiably high even after negotiating with your lender, you could consider presenting your case to a bank ombudsman or an independent mortgage consultant for arbitration.

Alternatives to paying penalty fees

If your reason for terminating your mortgage is the sale of your home, you could consider passing on the mortgage to the buyer instead of terminating it. If your mortgage rates are much higher than market rates, you could compensate for the difference by providing a discount on the sale. Note that a higher amount of debt means tax savings for the buyer and lower property gains tax for you as the seller.

If you plan to buy another piece of real estate after selling your apartment or house, you can ask the lender to transfer your remaining mortgage to your new property.

More on this topic:
Mortgage calculator: Early termination
Unbiased mortgage comparison
LIBOR-based mortgages in Switzerland
LIBOR explained