Please send your queries to Dominic Coyle, Q&A, The Irish Times, 11-15 D'Olier Street, Dublin 2, or email to dcoyle@irish-times.ie. This column is a reader service and is not intended to replace professional advice. Due to the volume of mail, there may be a delay in answering queries. All suitable queries will be answered through the columns of the newspaper. No personal correspondence will be entered into.
Mortgage fix
I have a fixed mortgage with AIB Bank at 9.45 per cent interest, fixed to September 2006. The amount I owe on the mortgage at present is £26,609. I asked AIB for a variable interest rate mortgage and they quoted me £3,786 as a penalty for breaking the fixed mortgage. I read in the business section of The Irish Times recently that financial institutions were charging between three and six months interest on breaking a fixed mortgage. AIB is charging me far in excess of this.
Mr E.Y., Tipperary
There is one key point you neglect to mention and that is the term over which you took out the fixed rate in the first place. However, judging from the interest you are paying, I would assume it was a 10-year fixed rate contract taken out in 1996.
It is terribly frustrating to sit there paying more than 9 per cent interest when variable rates are only a fraction of this.
However, AIB is perfectly entitled to do what it is doing in assessing the penalty it will impose on you if you seek to break the contract, notwithstanding what you have read about mortgage lenders in general charging between three and six months interest to break such contracts.
The whole question of calculating mortgage interest rates and penalties for breaking fixed rates is enormously complicated. However, the theory behind penalties for breach of such contracts is simple.
Basically, when you approach a financial institution for a loan, it has to go into the money markets to secure that money. It's not like they keep a stash of millions uninvested in their vaults; that would be a quick way to go out of business as a public company.
If you want a variable rate, it is relatively easy as you simply pay the rate in the market at the time plus an amount which represents the margin the bank or building society charges for its services. When this goes up, so, almost always, do your mortgage repayments, when it falls, theoretically, so should your mortgage payments. The margin charged by the banks covers their costs and profits on the deal.
Margins explain why you do not always get or pay the full amount when national - or in our case euro-zone - interest rates fall or rise.
In times of greater competition or when rates are particularly low, financial institutions are forced to cut their profit margin to get and retain business. At other times, they may decide to improve their profit margin because demand for loans means they can.
The situation with fixed loans is different in that, when you borrow for a 10-year period at a fixed rate, the bank theoretically has to buy that money at whatever rates are available in the market for a loan over such a term.
The fact that you decide you want to end the contract early to switch to a lower variable rate doesn't mean the financial institution can end its contract for the money it secured to give you the loan any earlier.
As a result, the bank or building society will generally charge you the difference between what your current loan would cost to repay and what the variable rate is. In broad terms, if you consider variable rates are going to continue falling, you might be advised to take the chance and pay the penalty. If, on the other hand, rates look as though they may rise further - as most pundits reckon just now - then you need to think carefully whether the penalty is worth paying.
All this is merely a layman's version of what are very precise and detailed mathematical forecasts and calculations conducted by actuaries. Their job is to ensure their employer, in this case the bank, does not lose out on the deal. It is not that they rig the figures in any way; it's just that actuaries are, by nature, a careful bunch and they will err, if at all, on the side of caution.
There is a lot of talk of three to six-month interest penalties but these generally relate to shorter-term loans - one of three years. You are more likely to pay a higher price for breaking a longer-term loan, especially in the early years, as the risk to the financial institution is greater.
It is also true that when rates are rising, it is sometimes possible if you approach your lender to have such penalties waived.
This is because, the bank - which is already committed to paying a certain rate for the loan - may be able to net greater profit by lending it on.
For example, say the bank loaned you £50,000 over 10 years at a fixed rate, say, 8 per cent when variable rates were 5 per cent and rates subsequently rose. After five years, you might owe, say, £35,000 but might decide to switch to a variable rate now running at 7 per cent - maybe because you are now more secure and can take a chance on variable rates or because you have a hunch they are going to fall again. The bank might agree to waive any penalty, because with variable rates now 2 per cent higher than when you took out the loan, fixed rates are certain to be higher than the 8 per cent you were paying. The bank might realistically expect to lend that same money for the five-year balance of the 10-year term at, say 9.5 per cent, thus making more money for itself.
The figures are pure fiction but the theory works and that explains why, in the current environment, where rates are rising and banks can earn more for their money, such cut-price penalties are possible.
Unfortunately, assuming yours is a 10-year loan taken out in 1996, the rates now are still below what they were then and the bank would find it hard to retain its margin on the money. As a result, it will be reluctant to do a deal.
Your situation shows precisely why people should be careful in taking out fixed-rate loans. Remember, while it is something of a gamble as to whether rates will rise, the experts (the actuaries) are setting the rates and neither they nor their employers expect to lose.
There are still valid reasons to take out a fixed-rate loan, not least the security of knowing what the payments are, month-to-month, over the early, tougher years of a mortgage or as protection against sudden market swings such as the ERM crisis when variable interest rates were well into double figures. But the advice to anyone taking out a mortgage is to think carefully before you choose.
