Halifax - can anyone work out thier redemption formula ?

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Has anyone ever made sense of what their Halifax breakage/ early fixed rate redemption fee is, using the Halifax redemption formula below ?

I have not gotten a straight answer from them yet as to what monetary values they applied to A,B,C & D when calculating breakage fee as applied to my mortgage.

Any mathematical whizzes out there to show me how it works on a simple mortgage example ??

A redemption fee will be payable by you based on the following formula:
(A - B) x C x D where:
A: is the Cost of Funds to the Bank, at the date of making the loan, at a fixed rate
B: is the Cost of Funds to the Bank, at the date of redemption of the loan, for the remaining period of the loan at a fixed rate
C: is the remaining term of the loan at the fixed rate
D: is the current balance of the loan at the fixed rate of interest


If B is greater than A, at the date of redemption of your mortgage loan, no redemption fee will be payable
 
It's not particularly simple but for various reasons I've looked closely at how this stuff works.

The first problem is that the "Cost of Funds to the Bank" is not the interest rate you pay for the loan - it's a "wholesale" interest rate set centrally by the banks treasury department. The branch then adds a one or two percent for their profit when they quote you a rate. Thus you are unlikely to verify the formula externally as you will not know what this internal "non-retail" interest rate is. However without getting into too much detail, these rates will very closely mirror those of the markets.

Another subtlety is that fixed interest rates also vary by term - called the yield curve; borrowing for longer normally incurs higher interest. There are two separate interest rates involved in the breakage fee calculation - the original rate when the loan was taken out is for the full term (e.g. a 5 year fixed rate) and the rate for the remainder of the term (e.g. say you decide to break the loan 2 years in, this will be the 3 year rate at the time of the breakage).

The easiest way to understand how this stuff works is to think in terms of the bank branch simply being a retailer for wholesale fixed term borrowings.

It is also far simpler to work through an example using an interest-only loan/mortgage instead of a regular mortgage. It works the same in both cases.

Say you borrow 100k interest-only at 5% for 5 years fixed but after 2 years you want to pay back the 100k early. Conceptually, what happens is that the branch originally borrowed 100k on your behalf for 5 years; at the time of your loan, the wholesale 5 year rate was 3.5% so the bank branch can expect the customer to pay 5k a year out of which it pays the 3.5k and pockets the 1.5k as profit. However the bank branch is completely locked into this repayment schedule - unlike the customer who can redeem the loan early. So no matter what, they have to pay 3.5k a year (as well as the 100k at the end since this is interest only).

When you subsequently break the term after two years, the bank branch is still stuck with the original 3.5k/year repayment schedule for the rest of the term (3 years). The nature of the wholesale loan is that it cannot be repaid early.

So how can the bank allow you to pay off the loan early at all? It is a little counter-intuitive; when you arrive with your 100k to pay off the loan early, the bank branch takes the 100k early repayment and invests it in the money markets getting a 3 year fixed rate. If the current 3 year interest rate is higher than the original 5 year rate (e.g. the 3 year wholesale rate is now 4.5%), then the interest it earns on LENDING the 100k to the markets (4.5k a year) will cover the 3.5k it has to come up with to pay for the original loan. Now the bank branch won't necessarily be delighted - remember they were making 1.5k a year profit before and now they're only making 1k but at least they're not losing money so they do not charge you a breakage fee. We can ignore this case.

However, if interest rates have dropped and the three year rate is now only say 1.5%, then the bank branch can only make 1.5k a year by investing the 100k which was redeemed early. This leaves them with a shortfall of 2k a year to pay off the 3.5k on the original wholesale loan. There are 3 years left in the loan, so this gives you a total shortfall of 6k. This is actually a real cost for the branch and so they recover it using a "breakage fee".

Looking at the quoted formula, with the above figures, we have:
A is 3.5%
B (3 year fixed rate) has dropped to 1.5%
C is three years.
D is 100k
Thus they will charge you (3.5% - 1.5%) * 3 years * 100K which is 2% * 3 * 100,000 which is 6K which matches what I derived above without using the formula.

Note that this explanation is conceptual.
 
That's a good example alright.

It's best to think of (A - B) as representing the change in the interest rate.

Applying this to your outstanding mortgage (D) will give an annual change in the interest payable due to the change in interest rates.

Finally, C would be the length of time you would be paying the difference for.

In general the breakage fee is designed to match the extra amount you would pay over and above the current rate over the remaining fixed term.

This means that you should be indifferent between breaking out if you believe current interest rates will not change.

Up to relatively recently many institutions used a simpler rule of 6 months interest. This could be a significantly lower penalty than the type above, with the effect that those with this type of penalty would be far better off breaking out. It's a good thing to try understand what's in your contract.

I believe many people are losing out because they are not going through their contracts, they'd rather call Joe Duffy!
 
By the way, this is probably off topic but I believe that both the other breakage formula that I've looked at and this Halifax one disadvantage the customer by not discounting the shortfall. In my example above, you should not be charged the nominal value of the shortfall at the time of breakage but the present value of the future cash flow required to fund the shortfall. This may not be a huge amount but it's easy to construct examples where the customer pays significantly more than the cost of the breakage to the bank branch.

For example, if you broke the term of a 100k (say interest only again for simplicity) fixed at 5.5% (say the "Cost of Funds to the Bank" is 4.5%) loan with 10 years to run and currently the 10 year cost of funds to the bank is 3%, then the bank would charge you 15k to break the loan (10 years of a 1.5K shortfall). However the 1.5k a year for 10 years should by rights be discounted and its present value charged to the customer (roughly 12,800 in this case) not it's nominal value.

Thus, along with DerKaiser's advice, I would be very careful - depending on the formula - of breaking a fixed loan where there is 5 or more years to run as this difference becomes significant and is certainly to the customer's disadvantage.
 
Thanks Darag and DerKaiser.
You have explained the application of formula in easy to understand terms.
I could not get my head around the formula but you have both made it easy to understand.

I wonder why Halifax have not made it so transparent
 
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