Understanding the Logic of Early Repayment Charges

JP08

Got a Nationwide 5 Yr fixed mortgage. This has an early repayment charge clause of 5% of balance remaining + £90 redemption fee ... though the latter appears to be £0 on my mortgage statements now, and I have some vague recollections of banks / building societies being told they weren't allowed to charge them any more.

Now - I have no qualms with the clause. It's in the contract I signed and I remember it being pointed out that ERC's appy. So no bones there. Ditto the redemption fee, whether it now applies or not.

And it makes no real odds whether we pay the outstanding balance now or later - just would be nice to get it all paid off.

What I don't quite understand is the logic.

Up until January this year the ERC would have been less than the amount of interest the Nationwide are going to get between now and Nov 17 (when the fix ends - the mortgage technically has another 5 yrs to go, but it has been overpaid to the max £500 every month for the last two years and will be paid off the day after the fix ends).

Now the ERC is significantly more than the interest they are going to get (£1500+ versus £800 interest)

This assumes that the £500 max allowed overpayments continue until Nov '17 then I pay off the lump sum remaining (about £15k)

And I really can't think of any logical reason why any lending institution would not want it's money back early - I'd even understand it wanting the £800, but not to charge you for making it wait for its money.

Anyone out there in moneylending world shed some light on this for me ?

Brock_and_Roll

Forget about the overpayments, lets keep things simple.


When you fix a mortgage for say 5 years you have the security of knowing how much interest you have to pay over the period. However, this transfers the interest rate risk to the bank.


If interest rates fall during the fixed period, the bank is in the money as it receiving a better return relative to its cost of funds. Conversely if rates rise, it would earn less or even lose money on the deal.


So as banks tend to, in part "fund short, lend long" (i.e. the borrow money in them markets for say 3 months then led to customers for 5 years+) then need to hedge themselves against interest rate risks.


They do this partly by taking out interest rate swaps - basically a contract that swaps a profile of fixed rate payments in return for a matching profile of variable rate payments.


So once the swap is established, the customer has a fixed rate and the bank is certain of its margin. However, in the even that the customer terminates early, the bank has to "break the swap" - this can result in a profit or a loss to the bank depending on what has happened to interest rates.


Of course this is all done on a huge scale - the bank "blends" together the profiles of thousands of mortgages before taking out a large swap - but the maths and theory is the same.

JP08

Okay - get that (sort of), though I don't see why they would "have" to break the swap if in loss and I'm happy to pay the interest they would have got anyhow ... let it ride until the agreed end and known amount surely? Meanwhile the cash they weren't expecting is sitting on their books ? Everyone ends up where they expected to at the start then ...

And the bit that is really confusing me is why, for three years of this fix, the terms are in my favour to early repay, but works out worse now. I'm hunching towards the overpayments messing up the logic actually ...