Early Repayment Charges: Costs, Rules and Smart Strategies

When taking out a mortgage, many borrowers typically focus on the lowest interest rate and monthly payment that they can secure for the longest period, typically five years. One crucial aspect that is sometimes overlooked, however, is the early repayment charge (ERC) that applies if the rate for that period is a fixed rather than a tracker rate. An ERC can have a significant financial impact if you decide to exceed your annual capital overpayment limit or repay your mortgage or remortgage during the fixed rate period. This article explores some key features of ERCs that borrowers should be aware of and consider when they obtain a mortgage or remortgage or refix the rate on an existing mortgage and choose a fixed rate.

What Is an Early Repayment Charge (ERC)?

An ERC is a financial penalty imposed by lenders when borrowers pay off all or part of their mortgage before the end of a fixed rate period, which, if applicable, is often two or five years’ long. Typically expressed as a percentage of the mortgage balance, ERCs commonly range between 1% and 5%, though the specific terms can vary by lender. The purpose of these charges is to compensate lenders for the potential loss of some of the interest income that they had anticipated from you over the fixed rate period due to your ending that period early with respect to a capital amount exceeding the annual penalty free overpayment limit, which is usually 10% of the outstanding mortgage balance. Many lenders structure the ERC on a sliding scale, with a higher rate at the start of the fixed rate period but reducing each year as the fixed rate period progresses. Thus, for example, the ERC rate might be 5% during the first year of a five-year fixed rate period, 4% during the second year, 3% during the third year, 2% during the fourth year, and 1% during the fifth year. This means that the financial impact of an ERC depends not only its percentage rate, but also on how far you are through your fixed mortgage rate period, as well as how much of your outstanding mortgage balance you choose to repay that is in excess of the annual penalty free overpayment limit.

Why Lenders Impose an ERC

Lenders use an early mortgage repayment fee to offset potential losses that they might incur when borrowers exit fixed rate deals early. As such, the ERC is designed to compensate lenders for potential losses of interest income. Fixed mortgage rates are agreed by lenders with the expectation that borrowers will pay that rate on the entire mortgage balance (over and above the annual penalty free overpayment limit) over the whole of the fixed rate period. Lenders typically plan their own funding arrangements, including managing funding cost risk through the use of interest rate swaps, accordingly. When a borrower exits early, it can disrupt those plans and projections and lead to losses. As a result, ERCs are built into the contract to protect the lender’s business model and financial plans.

How Early Repayment Fees Are Calculated

Percentage of outstanding balance: Most fees are based on a percentage of the remaining mortgage balance, subject to annual penalty free overpayment limits. This means that the larger your outstanding loan, the higher the ERC will be.

Tiered structure: ERC percentages often reduce over time. For instance, a 5% fee in year 1 might fall to 1% in year 5, making it less expensive to repay the loan later on during the fixed rate deal period.

Overpayment penalties: Exceeding the lender’s allowed annual penalty free overpayment limit (typically 10% of the outstanding mortgage balance) will also typically trigger the ERC. The penalty usually applies only to the portion of the overpayment beyond the permitted threshold.

Which Mortgages Carry an ERC?

Mortgages with fixed rates: Mortgages with fixed rates nearly always include ERCs, in order to protect lenders if you exit early. These deals lock in your interest rate for a set term, usually two or five years, and breaking that agreement early typically comes with a penalty.

Tracker or variable rate mortgages: Mortgages with tracker or variable rates, rather than fixed rates, are typically not subject to early repayment charges when those rates apply, which, like fixed rates, can typically be set for two or five-year periods.

When Will You Pay an ERC?

You will be charged an early mortgage repayment fee in these situations:

Full repayment before the end of your deal: If you repay the entire mortgage balance before the fixed rate deal period ends, you are likely to incur an ERC. This applies whether you are using savings, an inheritance or proceeds from selling your property to repay the mortgage.

Overpaying above the annual allowance: Most lenders let you overpay up to 10% of your outstanding mortgage balance each year without a financial penalty. If you exceed that limit, the excess amount is likely to be subject to an early repayment fee if this occurs during a fixed rate period.

Remortgaging before the deal ends: If you switch to a new lender before your current fixed mortgage rate deal period expires, it is likely that you will have to pay an ERC. Even if the new deal under the remortgage offers a better rate, the cost of the fee could potentially offset the savings.

Downsizing or porting improperly: If you sell your home to downsize and do not port your mortgage correctly, you may trigger an ERC. The same applies if the lender will not let you port the mortgage or if the new property does not meet their criteria.

Strategies to Minimise or Avoid an ERC

Check deal end dates: Plan actions, such as overpayment, repayment, porting or remortgaging, to coincide with when the fixed mortgage rate deal period ends.

Use overpayment allowances: Maximise penalty-free overpayments and reduce interest without incurring an early repayment fee.

Explore flexible or tracker deals: Consider tracker mortgage rates, which usually do not incur ERCs.

Port the mortgage: If considering moving house, ask your lender if you can port the mortgage without incurring ERCs.

Conclusion

Understanding ERCs is important for smart mortgage management. These penalties protect lenders from revenue losses triggered by early exits, but they can be minimised or avoided by choosing tracker deals, leveraging overpayment allowances, timing remortgages appropriately and exploring porting options. Ensure you fully review your mortgage documentation and consider getting advice and assistance from a mortgage broker.

FAQs

Q. What is an early repayment charge (ERC)?

A. An ERC is a fee charged by a mortgage lender when you repay your mortgage in full or in part over and above the annual penalty free overpayment limit before the end of a fixed rate deal period, usually two or five years’ long.

Q. How much does an ERC typically cost?

A. ERCs are usually calculated as a percentage of your outstanding mortgage balance and commonly range from 1% to 5%. The exact amount depends on your lender, the terms of your mortgage and how far you are into your fixed mortgage rate deal period.

Q. When are ERCs applied?

A. You may face an ERC if you repay your mortgage early, overpay more than your lender allows in a year (typically 10% of the outstanding mortgage balance) or switch to another lender before your current fixed rate deal period ends. Even moving home without properly porting your mortgage can trigger the fee.

Q. Can I avoid paying an ERC?

A. You can avoid an ERC by waiting until your deal period ends, staying within your lender’s overpayment allowance or choosing a mortgage product with no early repayment restrictions, such as a tracker rate.

Q. Are ERCs always a bad thing?

A. While they are an added cost, sometimes paying an ERC can be worthwhile, especially if switching your mortgage would save you more in the longer run. It is important to weigh the cost of the fee against the benefits of repaying early or remortgaging.

Additional Sources:

https://www.charcol.co.uk/news-and-opinions/mortgage-property-blog/erc-mortgage-early-repayment-charge-19848/

https://www.finder.com/uk/mortgages/early-repayment-charges-the-complete-guide

https://www.landc.co.uk/mortgage-guides/early-repayment-charge

https://www.onlinemortgageadvisor.co.uk/mortgage-repayments/what-is-an-early-repayment-charge/