Bernard Hickey: If it ain't broke, don't refix it

New Zealanders desperate for any form of immediate cost saving are making a huge mistake by choosing to break out of fixed mortgages and slapping the subsequently huge break fees back on to their mortgages.

It seems like a good idea in the short term, but borrowers will pay for this decision with a bigger debt and more interest payments over the life of the mortgage.

Banks report an increase in "capitalising" of break fees in the past three to four months. Some say as many as half of the 50,000 borrowers who have moved to variable rates from fixed rates may have capitalised the break fee on their mortgage.

A back-of-the-envelope calculation suggests that New Zealanders have added up to $500 million to the national mortgage debt over the past few months by doing this.

Most banks do not encourage it, but have little choice but to accept the decision, which is often suggested by brokers.

Some borrowers can't do it because they don't have enough equity in their homes to increase their loan-to-value ratio, particularly now that banks often limit these ratios to 80 per cent. But many have some equity left, even though house prices are falling.

Here's how it works. A mortgage borrower with, say, a $300,000 interest-only loan with four years to run at 8.95 per cent is currently paying around $516 a week in interest payments.

The temptation is to break out of that loan to reduce the interest rate to 5.8 per cent and cut the weekly repayments to $334. The huge carrot of a $182-a-week reduction in interest costs is often too tempting.

The break fee on such a mortgage would be around $34,400, depending on the bank. Even with the break fee added to the mortgage, the lower interest rate means the weekly payments of around $373 a week deliver an apparent saving. But it is only apparent.

Over the life of a mortgage, the decision to capitalise the break fee will cost a total of $61,572 at current interest rates, including interest on the original break fee over a 20-year mortgage. This works out at an extra $60 a week. This also assumes interest rates don't rise.

The big picture here is familiar. Borrowers desperate for a short-term consumption fix are borrowing for the long term and storing up more debt that will eventually have to be repaid and serviced.

This is the fundamental problem with the New Zealand economy, although we are not alone as this dilemma is dragging down most other developed consuming economies, too. We spent too much and now we have to repay the debt.

Adding to that debt will reduce the flexibility of borrowers if they lose their jobs in the next year or two. It directly reduces the equity buffer left in a house to rely on in the event of a real emergency.

The decision about breaking a fixed-rate mortgage and capitalising the break fee should be the catalyst for any borrower to have a fundamental rethink about their lifestyle, their debt levels and their appetite for risk when it comes to interest rate movements.

Before they break and capitalise, borrowers should ask what costs they can cut; how they can repay the debt earlier and what assets they can sell to repay the debt.

The answer should not be to borrow more and worry about paying it back later.

* Bernard Hickey is the managing editor of www.interest.co.nz, a website for investors and borrowers wanting free and independent news and information about interest rates, banks, finance companies and the economy.