Fixed Loan Break Fees

[Rolf Latham]

Hiya Sun

I aint no expert, and certainly not a specialist in fixed rates

Fixed rates for me and when clients ask, are not about getting a "better" deal at any point in time, but about managing risk of loss.

If you are a marginal borrower, in that I can JUST afford this, until 45 days ago, the average punter would have to hedge their bets on a fixed rate.

90 days ago the RBA and the government were still talking about braking our run away economy, and many many forecasters were talking double digit cash rates, with some talking 14 % retail ( please note there is still some risk of this in my view in the middle term of around 2 to 4 years, if the only vehicle we have to slow inflation is rates)

Now, the economy looks broken, rather than "braked", largely due to perceptions from offshore fallout, and a likely loss of consumer confidence.

And if you are in a fixed rate, and the lowering of the floating rate leaves you high and dry.................tough bickies. You are now in managing hindsight risk, rather than managing riks of loss.

ta
Rolf

 

[WinstonWolfe]

To take this you would need to be very aware that there would likely be a few years when it was above variable, but after that you could be laughing like a big green spider.

Any experts see it that way?

I think this topic was discussed in another thread and I raised the Risk/Reward formula to appraise the relative benefit of fixing vs not.
i.e.

Expected Return = Probability of winning * Size of win - Probability of losing * Size of Loss.

Consider 2 Scenarios

Scenario 1.
I fix a loan at 7%. I am better off when the rate goes above 7% and worse off when the rate is below. So say we have the following probabilities

60% chance of loan averaging 7%+2% over next 5 years
40% chance of loan averaging 7%-2% over next 5 years

The formula would look like this:

= (0.6 * 0.02 * 5 * 500000) - (0.4 * 0.02 *5* 500000)
= 10000

By fixing I am 10000 better off because for 20% of the time, the 7% I am paying is lower than the expected rate.


Scenario 2.
But real life isn't that simple. If our serviceability maxed out at 12%pa, and we had to liquidate property, the odds might be:

20% chance of loan going over 12% and being forced to liquidate at a loss of 135,000
40% chance of loan averaging 7%+2% over next 5 years
40% chance of loan averaging 7%-2% over next 5 years

Applying the additive law of probability, we get:

= (0.2*135000) + (0.4*0.02*5*500000) - (0.4*0.02*5*500000)
= 27,000

By fixing, I am 27k better off.

When downside risk is properly considered, fixing makes a lot of sense.

Though many people make the mistake of not accounting for a "Black Swan" event such as being forced to liquidate into a declining market.

 

[plusnq]

Hi WW

Great explanation of expectancy wrt housing rates. Kudos to you.

Most investors would do well to understand expectancy.

Cheers

Shane

 

[keithj]

It was suggested to me by the head guy at a RAMs branch that if selling early we could pay down the loan to say $2000 and transfer security of that $2000 across to another property so as not to incur the $7000 fee.

You extremely clever *******. Problem is that the new financier would come in as a second mortgagee - not sure they will go for that.

That's what I did last yr with an Adelaide Bank Lo-Doc - saved me $7K ish. I drew down my margin loan to pay off all but $2K, then asked for a payout figure (which was coupla hundred). Then refinanced with another lender and put the $$ back into the margin account.

From their POV the idea to extract penalties if I want to refinance with another lender.

 

[keithj]

Though many people make the mistake of not accounting for a "Black Swan" event such as being forced to liquidate into a declining market.

Any ideas about What Black Swans to take into account ? and also How to take them into account ?

 

[WinstonWolfe]

Any ideas about What Black Swans to take into account ? and also How to take them into account ?

Is one better off being ignorant of some downside risks?

of course the difficulty is making realistic assumptions and attaching appropriate probabilities....but better to make an effort to be informed than remain ignorant or say it is all too hard or scoff at the likelihood of extreme events.

happened to LTCM, and a stack of people I know who thought they were safe on 50% LVR on their margin loans recently.

Warren Buffett has said he would never play a game of high risk such as placing a gun to his head that had 1000 bullet chambers and one bullet, even if the payoff was a Trillion $..... because the downside risk is just too high....he values being alive more than any amount of money.


-for a lot of people, rates going over 12% would be a black swan

- house prices softening enough for lender to want borrower to inject more equity at refinance time.

- house prices softening enough for a revaluation to be lower than previously, and LOC being reduced.

- LOC or redraw facility being partially frozen by banks.

- in the case of a severe recession, govt preventing LLs from putting up rent to cover rate rises or evicting tenants if they are at extreme risk of being made homeless.

- Aussie bank run causing LOCs and redraws to be frozen.

- banks demanding a minimum monthly cash pmt on a property loan, rather than letting 100% of interest be capitalized.

- losing your $100k+ job in an economic downturn.

- serious health issues jeopardizing income beyond income protection insurance cover.

 

[keithj]

Is one better off being ignorant of some downside risks?

Of course not.

of course the difficulty is making realistic assumptions and attaching appropriate probabilities....

The point of (serious) question I asked was - 1 in 100 yr events (such as those you listed below) are such insignificant factors in the Expectancy equation as to be irrelevant.

The problem is that if we took all the possible extreme events into account before investing then no-one would ever invest.

IMO far better invest using a simple expectancy equation (and ignore, but be aware of 1 in 100yr events), and ADAPT if and only if black swans appear on the horizon.

.... happened to LTCM, and a stack of people I know who thought they were safe on 50% LVR on their margin loans recently.

ASX down 42% is a 1 in 100yr event, it's unlikely to happen in anyones investing lifetime. However, a 50% LVR only requires 28% fall (assuming 70% max allowable LVR) before a margin call. 28% falls happen every couple of decades, so IMO that's not a black swan event.

Warren Buffett has said he would never play a game of high risk such as placing a gun to his head that had 1000 bullet chambers and one bullet, even if the payoff was a Trillion $..... because the downside risk is just too high....he values being alive more than any amount of money.

Does Buffett ever cross a road ? Chances of getting run over by the proverbial bus are greater than 1 in 1M, but the payoff is trivial ? The point is - some extremely unlikely downside risks must be accepted in order to gain seemingly trivial upside.

Black Swans have the benefit of tending to cull the weaker/riskier in a population, leaving opportunities for the stronger and better managers of risk.

 

[WinstonWolfe]

Of course not.

The point of (serious) question I asked was - 1 in 100 yr events (such as those you listed below) are such insignificant factors in the Expectancy equation as to be irrelevant.

Whether a factor is significant or not is determined by probability * payout, not either/or.
A low probability can be offset by a large payout.


The problem is that if we took all the possible extreme events into account before investing then no-one would ever invest.

I disagree. I think we'd just be better risk takers, and wouldn't blow up.

IMO far better invest using a simple expectancy equation (and ignore, but be aware of 1 in 100yr events), and ADAPT if and only if black swans appear on the horizon.

A black swan is different things to different people. You see that on the forum. Some have remained more bullish about property and shares over the last 12 mths than others. Why? because of their approach to risk management and how that effects the information they seek out and what they do with it.

IMO, people who take risk management more seriously, identify earlier when black swans appear on the horizon. They are asking the right questions, collecting the right information, adjusting the probabilties earlier and more accurately.


ASX down 42% is a 1 in 100yr event, it's unlikely to happen in anyones investing lifetime.

It just happened....XEJ, XMJ, XFJ, XDJ have all lost over 42%.
A more informed risk manager would have been adjusting their LVRs below 50% over the last 12 mths.

1 in 100 year events can occur three times in 30 years and then not again for 270 years. And one has to be always aware of their assumptions. To say a 42% decline in the ASX is a 1 in 100 year event, based on 100 years of records, is not a statistically strong sample size.

Further, ASX falls are not purely random events. They are subject to human behaviour and the structure of free markets that are partial to economic cycles, and the advance and decline of economies/nations.

However, a 50% LVR only requires 28% fall (assuming 70% max allowable LVR) before a margin call. 28% falls happen every couple of decades, so IMO that's not a black swan event.

One man's black swan might not be another's.
Do you think those who have had margin calls in the last 6 weeks would consider the market's recent decline a black swan? You'd have to presume they thought it was unforeseen or so low as to be "irrelevant".

Does Buffett ever cross a road ? Chances of getting run over by the proverbial bus are greater than 1 in 1M, but the payoff is trivial ? The point is - some extremely unlikely downside risks must be accepted in order to gain seemingly trivial upside.

Black Swans have the benefit of tending to cull the weaker/riskier in a population, leaving opportunities for the stronger and better managers of risk.

I agree with your last paragraph. And understanding the expectancy equation helps one better manage risk.

 

[plusnq]

Of course not.

The point of (serious) question I asked was - 1 in 100 yr events (such as those you listed below) are such insignificant factors in the Expectancy equation as to be irrelevant.

The problem is that if we took all the possible extreme events into account before investing then no-one would ever invest.

Probably agree

IMO far better invest using a simple expectancy equation (and ignore, but be aware of 1 in 100yr events), and ADAPT if and only if black swans appear on the horizon.

This requires some education and understanding of risk and macroeconomics. Most investors wouldn't have this and perhaps a simple inclusion of a 10 or 20% loss risk may improve their ability to survive? I think there are people who have some understanding of what may happen (Goldman Sachs) and there are those who have no idea (Lehman Brothers). And they were professionals ...using the term loosely.

ASX down 42% is a 1 in 100yr event, it's unlikely to happen in anyones investing lifetime. However, a 50% LVR only requires 28% fall (assuming 70% max allowable LVR) before a margin call. 28% falls happen every couple of decades, so IMO that's not a black swan event.

1982, 1987 and now are all greater than 28% falls

Does Buffett ever cross a road ? Chances of getting run over by the proverbial bus are greater than 1 in 1M, but the payoff is trivial ? The point is - some extremely unlikely downside risks must be accepted in order to gain seemingly trivial upside.

Message to self: look both ways


Black Swans have the benefit of tending to cull the weaker/riskier in a population, leaving opportunities for the stronger and better managers of risk.

Agreed. But wouldn't most people be better off either learning to manage risk or using a more conservative formula that may include some amount of calculation of extreme loss.The problem is that most people don't know what they don't know until it is too late. Look at the number of members of the forum that were piling into shares last year.

Hi Keith

See above.

Cheers

Shane

 

[Sunfish]

WW you are taking on a major task discussing "expectancy" here. I have been warning of the real risk of an event such as this for years now. I have always said "this decade" as the time frame and given (variously) 3 or 5 to 1 odds so as not to scare the sheep but privately thought it a near certainty if one extended the time frame a little. I doubt I got one +ve reply.

I even gave an example by Nasim Taleb showing that 5:1 odds of a bad loss more than outweighed the reasonable odds of a small win. As property is ill-liquid with high entry/exit costs my conclusion was that it was an unwise time to be buying. OK. I know that some of you will be saying "I bought after that. I'm doing OK!" That's not the point. If you didn't see the storm coming how did you know you had time before it hit? And how do you know it will still be OK next year?

Have any of you "youngsters" played cards, socially or at a gambling table? It's a lost art but maybe you should join a bridge club and learn, in a benign setting, odds and risk/reward. You would soon learn that being bold without good reason will have your partner hitting you over the head.

 

[keithj]

The problem is that if we took all the possible extreme events into account before investing then no-one would ever invest.

I disagree. I think we'd just be better risk takers, and wouldn't blow up.

Possibly from a purely statistical POV, but from a practical POV how do you calculate the probability of those black swan events? and how do you calculate the payoff ?

As an example of a black swan, you gunna calculate the probability of rising sea levels inundating your beach house, then calculate the probability of your local council building sufficient beach defenses, then calculate the probability of a storm event breaching those defenses ?

Or a 9/11 type event or one of those 10,000 near earth objects hitting your IP, or being sued for $20M, or a 1 in 100 yr decline in the ASX, or one of those others you mentioned.

IMO, far better to invest on a best guess basis, and ADAPT earlier than those less informed as the risk of those events increases above a specific (& individual) threshold.

We humans got to the top of the food chain, not because we can foretell the future, but because we have the ability to adapt.

IMO far better invest using a simple expectancy equation (and ignore, but be aware of 1 in 100yr events), and ADAPT if and only if black swans appear on the horizon.

A black swan is different things to different people. You see that on the forum. Some have remained more bullish about property over the last 12 mths than others. Why? because of their approach to risk management and how that effects the information they seek out and what they do with it.

IMO, people who take risk management more seriously, identify earlier when black swans appear on the horizon. They are asking the right questions, collecting the right information, adjusting the probabilities earlier and more accurately.

You appear to be agreeing with me. Invest using a simple expectancy formula, and ADAPT as black swans appear.

ASX down 42% is a 1 in 100yr event, it's unlikely to happen in anyones investing lifetime.

It just happened....XEJ, XMJ, XFJ, XDJ have all lost over 42%.
A more informed risk manager would have been adjusting their LVRs below 50% over the last 12 mths.

1 in 100 year events can occur three times in 30 years and then not again for 270 years. And one has to be always aware of their assumptions. To say a 42% decline in the ASX is a 1 in 100 year event, based on 100 years of records, is not a statistically strong sample size.

Further, ASX falls are not purely random events. They are subject to human behaviour and the structure of free markets that are partial to economic cycles, and the advance and decline of economies/nations.

I think you're continuing to agree with me.... ADAPT as events unfold (adjust to a lower margin LVR).

However, a 50% LVR only requires 28% fall (assuming 70% max allowable LVR) before a margin call. 28% falls happen every couple of decades, so IMO that's not a black swan event.

One man's black swan might not be another's.
Do you think those who have had margin calls in the last 6 weeks would consider the market's recent decline a black swan? You'd have to presume they thought it was unforeseen or so low as to be "irrelevant".

I think you're agreeing with me... they failed to ADAPT.

Does Buffett ever cross a road ? Chances of getting run over by the proverbial bus are greater than 1 in 1M, but the payoff is trivial ? The point is - some extremely unlikely downside risks must be accepted in order to gain seemingly trivial upside.

Black Swans have the benefit of tending to cull the weaker/riskier in a population, leaving opportunities for the stronger and better managers of risk.

I agree with your last paragraph. And understanding the expectancy equation helps one better manage risk.

We agree .

 

[Sunfish]

By Keithj:
Black Swans have the benefit of tending to cull the weaker/riskier in a population, leaving opportunities for the stronger and better managers of risk.

But if you don't consider risk you are setting yourself up to be one of the culled. 'Tis noble of you.

 

[WinstonWolfe]

As an example of a black swan, you gunna calculate the probability of rising sea levels inundating your beach house, then calculate the probability of your local council building sufficient beach defenses, then calculate the probability of a storm event breaching those defenses ?

Or a 9/11 type event or one of those 10,000 near earth objects hitting your IP, or being sued for $20M, or a 1 in 100 yr decline in the ASX, or one of those others you mentioned.

Don't forget the role of outsourcing some risk management Keith.....via property and LL insurance, income protection insurance, etc.

If your insurance company doesn't want to cover your beachfront pad because of the risk of storm surges, cyclones, global warming, meteorites, then that has to be taken soberly. If they want a premium to cover those things, then in an ideal free market, that premium should be passed onto the tenant or into ROI calcs.

We'd all be better off if we understood the risks we take....and related that back to risk free returns, if there is such a thing.

IMO, far better to invest on a best guess basis, and ADAPT earlier than those less informed as the risk of those events increases above a specific (& individual) threshold.


We agree .

I think where we agree is that risk management requires updating one's information constantly and plugging those changes into their expectancy equation, and adapting risk exposure accordingly.

Where I think we disagree is that you implied some risks REMAIN so small as to be irrelevant, at all times.

i.e.

"The point of (serious) question I asked was - 1 in 100 yr events (such as those you listed below) are such insignificant factors in the Expectancy equation as to be irrelevant."

"ASX down 42% is a 1 in 100yr event, it's unlikely to happen in anyones investing lifetime."

 

[keithj]

I have been warning of the real risk of an event such as this for years now. I have always said "this decade" as the time frame and given (variously) 3 or 5 to 1 odds so as not to scare the sheep but privately thought it a near certainty if one extended the time frame a little.

Didn't reach the risk threshold for 99% of the audience. ... and it shouldn't. If they'd listened in 2004, they'd have missed 50% gains in ASX, or 100% gains in Perth IP. In hindsight, you were right (eventually). But adapting only when the risks reach a certain threshold is IMO a better strategy than attempting to evaluate the probability and payout of extremely unlikely events from day 1.

Some (like Steve Keen) have been saying this debt crisis will happen for 20 years now.... and he has a higher probability of being right this time..... after 19 consecutive wrong years. Provided you're an early adapter when these events appear more likely then the risk of a disastrous outcome isn't as high as some would make out.

It's a lost art but maybe you should join a bridge club and learn, in a benign setting, odds and risk/reward. You would soon learn that being bold without good reason will have your partner hitting you over the head.

Yes... actually, we came 4th in the GNOT regional finals last month. I'd agree that being bold at the right time pays dividends. But also being bold against certain opposition pays out big too. Another advantage of joining a bridge club is you'll get to meet a few older,smarter,experienced or richer people who have experienced a lot of cycles and who are happy to talk to young upstarts who think they know all about risk.

 

[keithj]

As an example of a black swan, you gunna calculate the probability of rising sea levels inundating your beach house, then calculate the probability of your local council building sufficient beach defenses, then calculate the probability of a storm event breaching those defenses ?

Or a 9/11 type event or one of those 10,000 near earth objects hitting your IP, or being sued for $20M, or a 1 in 100 yr decline in the ASX, or one of those others you mentioned.

Don't forget the role of outsourcing some risk management Keith.....via property and LL insurance, income protection insurance, etc.

If your insurance company doesn't want to cover your beachfront pad because of the risk of storm surges, cyclones, global warming, meteorites, then that has to be taken soberly. If they want a premium to cover those things, then in an ideal free market, that premium should be passed onto the tenant or into ROI calcs.

Sure, but them you've got a whole new set of calcs to work out - likelihood of insurance cpy paying out, credit rating of said insurance cpy, and then credibility of credit rating agencies. The point I'm making is that some risks a so small & hard to evaluate that they are irrelevant regardless of the expected negative consequences. Practicality must override statistical purity regarding expectancy calcs.

And additionally, that IF those black swan events (that 99.99% of the popln has ignored) DO eventuate then my relative position compared to the rest of the population will remain the same. EG. IRs at 18% will hurt me, but it will hurt 95% of the population more. So, a) consequently it is unlikely to happen, and b) my absolute comfort level will be worse, but my relative comfort will be the same or better. So, I avoid being in that 5% (the bleeding edge) of risk takers.

We'd all be better off if we understood the risks we take....and related that back to risk free returns, if there is such a thing.

Mostly agreed from a pure expectancy POV. But from a practical POV, most successful people make their own luck and force probabilities to change in their favour.... which could be fed back into the calcs.

I think where we agree is that risk management requires updating one's information constantly and plugging those changes into their expectancy equation, and adapting risk exposure accordingly.

yes.

Where I think we disagree is that you implied some risks REMAIN so small as to be irrelevant, at all times.

I believe the only constant is change, nothing ever REMAINS, consequently, we must continually adapt.

 

[WinstonWolfe]

BTW, my thrust is not to encourage people to sit down and do a comprehensive expectancy calc taking into consideration an infinite number of variables. It'd take an inordinate amount of time for a start and the probabilities one came up with would most likely have such large std deviations as to make your final expectancy figure misleading.

i.e. referring back to the original Scenario 1. with a 10k win for fixing. Depending on the quality of the info behind the probabilities used, the 10k win could be accompanied by a 50k std deviation. The more probabilities used, the more variance will be in the final expectancy figure.

Nevertheless, I raised the expectancy formula to highlight two things:

- the importance of considering not only probability of something happening, but also the size of the payout, whether positive or negative....

- how being better informed allows one to calculate expectancy more realistically, because you are seeking more pertinent information in a balanced manner regrading the upside and downside.

The older I get, the more I see the wisdom in 'preservation of capital' as the first rule of investing....and that means prioritizing minimizing the downside.

Very successful guys I know have an intuitive sense for this stuff...expectancy is an automatic calculation in their head, especially on macro economic issues........Two I was talking with recently have gradually adjusted their asset mix away from property and shares towards cash (including 2 foreign currencies) and gold over the last 18 months.

 

[Nalima]

I was quoted $15500 to break a 7 year fixed loan at 8.46% with ANZ Bank. Their current variable rates is 8.57% and I have Proffesional package with them. I then decide to stay fixed for another 6.5 years.

 

[BoatBoy]

I was quoted $15500 to break a 7 year fixed loan at 8.46% with ANZ Bank. Their current variable rates is 8.57% and I have Proffesional package with them. I then decide to stay fixed for another 6.5 years.

$15k could just be looked at as the cost of doing business.

Fixed rates provided assurances when rates looked like going higher, but now it would seem it is a hinderence.

By paying the $15k, how much EXTRA cashflow will it provide every week?
If rates get to 6% how much EXTRA cash flow will it have provided then?

Extra cashflow not to buy more, but to help ensure survival.

As an example, for us, we have just paid $17k to get out of 7.5% which will be tacked on the end of existing loans.

If rates get to 6% this $17k will cost $19.60/week, but will save us about $170/week in interest.

If they drop to 5% that's $270/week extra

So, spend $20 to get $150, sounds like a good deal. How much would you need to renovate to get a $150 return each week?

Dave

This is general advice and a scenario for us, your circumstances and plans may be different

 

[Lukey13]

When you're locked into a fixed rate does it mean that you cannot pay out the loan at all without incurring the "break" fees?

For instance, is it possible to pay out the loan by selling a property to your family trust or somebody else?

 

[Peter 14.7]

Hello All

FYI I just broke my three fixed loans and thought I would post the detail.

Rate 7.64% fixed five years

$180k with 3yr 10 months to go $700
$180K with 3yr 10 months to go $700
$256K with 4yr 2 months to go $1800

Total cost $3600.

I did the numbers and a rate drop of 0.5% will pay back break cost in 12 months. Any more and I am in bonus land.

So whilst I usually stay fixed but I broke because:

1. strong likihood of rates dropping 2% more. All I need is 0.5%, that should happen on Melbounre Cup Day. Payback worth it. TICK
   
2. frees up to sell all of these IP in say 18 months and not incurr much larger break fees. May sell if market has boomed as 2 of the 3 are first home buyer stock. Tak ethe money and run TICK
   
3. lowers serviceability so could use CG to buy more IP TICK
   
4. allows to refix at bottom of the IR cycle, when ever that is. TICK

FYI I am all with CBA and whilst we all (and I included) bag the banks CBA have been pretty far about it.

SO if you are thinking about it, do it now.

Term and rate make huge difference to payout. If as we expect rates go down another 0.5% in Nov mine would have probably doubled to $6 to $7k. It is too complex to explain her but in the end I took a long term view and have a unique property in mind to buy maybe next year, so this ties in with that decision. I can either use the CG to buy it, or sell up and wear the CGT and find again.

The other lesson is form past lesson in mistakes

• I kept all loans free of each other so no X coll. Makes is much easier to pick and chose your strategy.
  
• And being with one bank makes it easier to get a single position.

Hope this is helpful.

Peter 14.7