Squirrel: Fixing your Mortgage Long-Term? Beware of the Break Fee!

In a changing interest rate environment, like the one we’re in right now, the question of how long to fix your mortgage can feel like a tricky one to get right. Squirrel’s John Bolton explains why you should beware of the break fee if you are tempted to lock in your mortgage to earn a lower long-term rate…

Beware of the break fee

In August, the Reserve Bank cut the Official Cash Rate by 0.25% – its first reduction since 2020 – marking the start of a gradual (and long-awaited) easing of interest rates over the coming months.

Since then, a number of banks have responded by dropping their short-term fixed rates.

The conundrum for borrowers right now, when it comes to deciding how long to fix for, is the fact that longer-term rates are currently sitting significantly lower than those at the shorter end of the spectrum.

For anyone who’s been stretched to their absolute limit by high mortgage costs over the last couple of years, that extra reprieve might seem like a no-brainer, but there can be hidden risks to locking in longer-term that people need to be aware of before they dive in.

What is a break fee?

A break fee is the penalty that borrowers get hit with if they opt to break and repay a fixed-term mortgage before it matures. For example, if you sell your house, or if rates fall sharply and you want to refinance to get a better deal.

Because break fees usually only become an issue in a falling interest rate environment, chances are that if you’ve entered the housing market in the past decade, you won’t have experienced them before.

But depending on the size of your mortgage, break fees can set you back tens of thousands of dollars. So it’s an incredibly nasty surprise if you’re not expecting it.

Why do banks charge a break fee?

Break fees cover a real and legitimate cost to the banks that’s incurred when you break your loan term.

When you break your loan with the bank, the bank is forced to break the funding arrangements it has in place with wholesale funders. The bank gets penalised for breaking its loan early, so it passes that cost on in full to the end borrower – with no discounts or waivers.

How are break fees calculated?

The last time break fees caused major problems for homeowners was in 2009, just after the GFC. And back then, I got myself in a whole heap of trouble for comments I made about the way banks were calculating these fees.

Basically, the calculation looks like this:

[Percentage fall in wholesale interest rates since you fixed the loan] x [Your loan balance] x [Years until the fixed rate matures]

It’s best illustrated with an example. You’ll note the calculation below is based on wholesale interest rates, a.k.a. the rate the bank borrows at, rather than the fixed-term mortgage rate. This is the bank passing on its cost: 

Let’s say a borrower opts to fix for five years at 5.95% and the wholesale funding rate, what the bank borrowed the money at, was 4.00%.

A year later, with four years left on their term and $600,000 left on their mortgage, the borrower wants to break the loan. At this point the wholesale funding rate has dropped to 2.75%.

So, the break fee would be calculated as follows:

The bigger the mortgage and the further rates fall, the scarier it gets.

Let’s say a borrower had fixed for five years at that same rate. If they chose to break the loan two years in, once wholesale rates had fallen from 4.00% to 2.00%, their break fee on a $600,000 mortgage balance would be $36,000.

Why are break fees something for people to keep in mind right now?

Based on the RBNZ’s latest forecasts, we’re likely to get another 0.50% reduction in the OCR before the end of this year, and a further 1% drop delivered incrementally throughout 2025.

The RBNZ has said that a neutral OCR – one that neither fuels nor restricts the economy – is 3%, meaning mortgage rates should fall back and settle somewhere between 4.5% and 5%.

Now, when it comes to the future of interest rates, nothing’s ever set in stone until it’s actually happened. The RBNZ may ramp up (or ease off) on its planned course of OCR reductions, depending on what happens with the economy over the coming months.

Broadly speaking, though, we can expect rates to track steadily downwards over the coming year or so.

That means that what looks like a competitive rate right now may not look so good in a year, once those falls have come through.

Fixing long-term at the moment means that when rates do (eventually) fall below the level you’ve fixed at, and you decide you want to break your loan term to get a better deal, you’ll have to pay through the nose for the privilege.

So, how long should you fix your mortgage for?

Before fixing in this environment, the best thing you can do is chat with a mortgage adviser, who can help you understand the implications of fixing short vs. long term and what’s going to be best for you given your situation.

If it were me, I’d steer well clear of fixing longer-term, for anything upwards of two years, despite the fact that these rates will likely continue to sit below shorter-term rates for a while yet.

Right now, the recommendation would be to fix for six or 12 months, or split between these terms. This avoids or minimises the risk of break fees and means that, once rates have fallen further, you’ll reap the benefits even sooner.