Capitalising exit fees if interest rates drop suddenly

[boomtown]

Having a bit of a ponder this lovely Saturday morning and woud like to ask people's thoughts.

I have a large purchase due to complete at the end of next week. Finance is in place - 100 percent fixed for 3 years. I like fixed loans because its important for my SANF - I will be running pretty close to serviceability thresholds for the next 12 months.

By the same token I am well aware of the interest rate cuts everyone has banked for the end of this year and 2009.

My thinking is that a few good cuts in interest rates should spur a mild recovery in property prices. If things get really crazy and the RBA drops rates by 200 basis points we could have a boom.

In these circumstances I would consider exiting my fixed position, paying the whopping exit fee (it could be 20k...) and locking in at the much lower rate to free up cashflow for another purchase. The exit fee would be capitalised.

I am thinking so long as the CG on the property prior to exit is, for example, four times the exit fee, it woudnt really hurt.

I haven't really thought this through yet but would like to hear what other people think about using this to "hedge" against lower interest rates.

 

[Rolf Latham]

Hiya

if you have the room to cap the exit cost, then youd have the room to cap the neg cashflow difference ?

ta
rolf

 

[boomtown]

Yes I would have the option of capitalising either the exit fee or capitalising a portion of the negative gearing equal to the "excess" interest component.

Which gives the better outcome though hmm. I suppose given the time value of money there is a certain appeal in capitalising the negative cashflow. The analysis would largely depend on whether you thought interest rates would revert to going back up I guess.

 

[Steve Cockrane]

Boomtown,

Firstly, I strongly doubt that things will go crazy and the RBA will cut rates by 200 basis points in the short term. But following your hypothetical if a boom did ensue after such a number of cuts in the next 12 months that we did see a 200 basis points cut.

My first point of call would be your loan contract, how do they calculate the exit fees? Is there a deferred establishment fee ( the kind Wayne Swan harps about) as well as break costs for ending your fixed term?

Lets take a best case scenario and just say there are break costs. Most lenders will charge the borrower the economic cost of breaking the loan contract. Lenders will look at what the rate of a comparable loan on similar terms can be sold at in order to calculate these costs.

Let's say for example you borrow $300,000 for 3 yrs at 9.50% 12 months. Later after a 200 basis point cut you want to refinance. The lender will look to the comparable 3 yr fixed term at the time you refinance. Let's say at the time you refinace the rate has also fallen 200 basis points to 7.5%. To calculate the exit cost therefore the economic cost will be 2% x $300,000 x 2 years (term remaining) = $12,000 exit costs.

An exit fee of 1 to 2% would just compound those costs and mean it may be better to suck it up and see out the fixed term.

The analysis would largely depend on whether you thought interest rates would revert to going back up I guess.

There is nothing surer than interest rates are a moveable feast, they will go up and down. Will they get back to the level we've seen in recent years, the lowest on record? Probably not. But nor do I believe will we see them climb to 17% as they did back in the last century.

You've done the right thing to manage your risk by fixing, the only thing I would have done differently is the term you fixed for (1 or 2 yrs max) in this current market. But if your numbers stack up at that rate then you are sitting pretty.

Cheers

Steve Cockrane

 

[boomtown]

Thank you for your consideration Steve. I tried to work through the mechanism by which the exit fee is calculated but it is linked to functions which are complex and not ascertainable in advance - what appears to me to be deliberate obfustication by the lender.

I have another IP loan (currently fixed at 7.35 percent) which expires Feb 2010. I am keen to keep an 18 month gap between expiry periods in case rates move heavily against me which dictates me entering into a 3 year fix on this product even if its quite possibly not the best I coud do. I just hope I don't completely miss the dip...

 

[GoAnna!]

The fees are normally imposed if you exit at a higher rate then the current fixed market rate. Why not watch them as they some down and exit just before the fees would be imposed (this is not referring to deferred establishment fees etc)

 

[granev]

Hi Boomtown

I also think that with your hypothetical , even if the RBA does drop rates 200 points , none of the banks will be passing it all on to you , so I reckon you would still be better off sitting your fixed loan out.

My crystal ball says that nothing is going to happen at too much of a hurry at the moment , so maybe by the time you have to worry about it , half your fixed period may be over.

 

[Sunder]

My thinking is that a few good cuts in interest rates should spur a mild recovery in property prices. If things get really crazy and the RBA drops rates by 200 basis points we could have a boom.

So... When the Fed cut their interest rates by 200bp in almost one move, what happened to their house prices?

If the RBA had to cut rates by 200bp in less than 12 months, then I'd say we'd be deeper into trouble, rather than excited for a boom. The only reason they'd cut so severely, so fast would be smashed domestic demand, and high unemployment.

No, I'd say it's a matter of "steady as she goes" and gently let the rates down. I believe historically, rates come down twice as fast as they go up, so 6 years up = 3 years down.

 

[boomtown]

Far outer ring LA is a bit different from Brisbane inner inner ring. Im not too concerned about those sorts of circumstances replicating themselves in New Farm.

I take your point about slowly falling IRs. Its more "what if" strategising than something I actually think is going to happen.

 

[Ausprop]

Swan has promised to have a solution for heavy exit fees before november, so i would wait and see what hat solution is first

 

[boomtown]

The fees are normally imposed if you exit at a higher rate then the current fixed market rate. Why not watch them as they some down and exit just before the fees would be imposed (this is not referring to deferred establishment fees etc)

I dont think thats possible - I would only be exiting after very large rate cuts so the bank would impose the "economic loss" calculation based on their interest revenue foregone.

Maybe I am misunderstanding your comment?

In more general terms, I think I would be better off capitalising the exit fee and refixing at a lower rate for an extended period (5 years?). So long as China keeps ticking over, if rates went down I would not trust them to stay down for long.

Anyway its all hypothetical and rather unlikely as others have pointed out.