Early Repayment Charge on a mortgage in the UK

Early Repayment Charge is a term that anyone considering overpaying their mortgage orremortgage, needs to be familiar with. It can significantly affect the cost-effectiveness of such a decision. Many mortgages contain a clause for an additional charge for early repayment of part or all of the obligation before a certain period. Failure to be aware of the existence of an ERC can result in the borrower incurring high costs instead of saving on interest, which can negate the financial benefits of overpaying or refinancing. In addition, with aremortgage, the need to pay an ERC can make it less cost-effective, and in some cases even unprofitable, to change the mortgage to better terms.

What is an early repayment charge?

An Early Repayment Charge is a charge for paying off a mortgage before the end of the contractually agreed period. Information about ERCs is always included in the mortgage contract, so it is worth reading this when taking out a mortgage.

The amount of this charge usually decreases with the term of the mortgage and is determined as a percentage of the remaining balance of the mortgage - for example, in the first year it is 5 per cent, in the second year it is 4 per cent and in subsequent years, it decreases by one percentage point per year. As we mentioned in the introduction, the Early Repayment Charge applies to both the overpayment of the mortgage and remortgage.

Why do banks impose early repayment charges?

There are several reasons why banks impose a charge called the Early Repayment Charge but, as you can guess, most of it comes down to money. If a customer repays a mortgage prematurely or refinances it, the bank loses earnings on the interest, which depends on the length of time the mortgage has been fully repaid. By imposing an additional charge, banks protect themselves against the risk of losing significant amounts of money. The Early Repayment Charge will not return the equivalent of the interest to the bank, but represents another few thousand pounds of profit. On the balance sheet of these institutions, this makes a huge difference.

The ERC Charge prevents massive refinancings, which would presumably have taken place as soon as the favourable terms at a particular bank had ended. If it were not for the Early Repayment Charge, banks would probably not offer such favourable terms at all as they do now, because they would have to limit the risk of losses resulting from early repayment of mortgages. The same applies to the possibility of a change in interest rates, on the basis of which banks determine the terms of mortgages. If these fall, competitors may offer mortgages on better terms, encouraging borrowers to refinance.

Another reason is the mechanism of the banks - they cover the costs of providing mortgages through various financial mechanisms, such as issuing bonds. The granting of a mortgage to a customer is based on the assumption of making a profit for a certain duration of the contract. However, the absence of an Early Repayment Charge could disrupt the liquidity of financial institutions because, when remortgaging, the bank would have to cover the interest on the bonds issued itself or break them prematurely. The ERC offsets this risk.

How much is the early repayment fee?

ERC rates at most banks are similar, ranging from 1% to 5% of the remaining mortgage balance. Their amount depends on the time remaining in the promotional period. For example, if you have one year left on your contract, the ERC will be 1%, and if you have five years left on your contract, the ERC will be 5%. However, the final terms may vary depending on the bank and the specific agreement.

The case is slightly different for partial overpayment of a mortgage . Banks usually allow you to overpay up to 10% of the current mortgage balance in one calendar year. A larger overpayment will result in a charge being levied on the excess at the applicable Early Repayment Charge rate.

Does early repayment of a mortgage affect creditworthiness?

Premature repayment of a mortgage can affect creditworthiness both positively and negatively. It depends on the situation.

Premature repayment of a mortgage will affect creditworthiness positively in the following situations:

• ReduceDebt-To-Income ratio - if the customer repays the mortgage early, they will remove their liability, which will improve their DTI ratio;

• Improving credit history - paying off a commitment with a positive history shows banks that the customer is a responsible borrower.

Premature repayment can also have a negative impact if:

• Will shorten credit history - if the mortgage was the person’s only commitment, paying it off will shorten the credit history, which will lower the credit score;

• The person will not have any active credit - some credit scoring systems place a premium on people who regularly service commitments.

Is it possible to avoid the Early Repayment Charge?

There are several methods to avoid or significantly reduce the ERC fee. The most popular, of course, is to make the mortgage repayment after the promotional term has expired. Usually, when the mortgage instalment changes from promotional to Standard Variable Rate (SVR), the Early Repayment Charge ceases to apply. Of course, there are exceptions, so be sure to read the terms and conditions of the particular mortgage described in the contract in detail.

It is also a good idea to spread the overpayment over several years. As mentioned earlier, usually banks allow you to overpay your mortgage with amounts totalling up to 10% of the outstanding balance per year. Using this limit, you can gradually overpay the mortgage over several years to avoid the ERC charge.

Another method to partially reduce the ERC fee is to take advantage of refinancing the mortgage with an ERC refund. Some banks offer to remortgage with ‘cashback’ or ‘ERC refund’ options to encourage borrowers to refinance with their institution. It is also possible that the terms of the new mortgage will be so favourable that the savings will also cover the cost of the ERC fee at the current bank. Then, admittedly, the Early Repayment Charge will not be avoided, but it could still be an attractive solution.

Mortgages without Early Repayment Charge are also available on the market. These are usually options with variable interest rates. Therefore, if you are considering taking out a mortgage and paying it off early, finding such a solution can be very beneficial for you.

Additional opportunities arise if you are buying your next property. In this case, you can negotiate with the bank to avoid the ERC fee in two ways:

• If you intend to take out another mortgage, negotiate with your bank to remove the ERC fee, provided you take it out with the same institution. Such an arrangement can be mutually beneficial;

• If you want to transfer your mortgage to another property, do a mortgage porting. Some banks will allow you to do this without requiring you to pay the ERC fee.

When is it better to pay the Early Repayment Charge and when is it better to repay the existing mortgage?

To determine the viability of carrying out a remortgage before the end of the promotional period, you need to calculate whether the costs associated with the ERC combined with the savings from remortgaging are lower than the cost of paying off the current mortgage until the end of the promotional period. To do this, you need data such as:

• Balance outstanding on current mortgage (L);

• The interest rate on the current mortgage (r_old);

• Remaining term to the end of the fixed rate period (n_old);

• Monthly mortgage instalment (P_old);

• ERC amount as a percentage of the remaining balance (ERC_rate);

• Interest rate on new mortgage (r_new);

• The term of the new mortgage (n_new);

• New monthly instalment (P_new).

Firstly, calculate the total amount of interest you will pay by the end of the promotional period. This can be achieved with the formula:

Total interest cost (I_old) = P_old * n_old - L

Then calculate the cost of early repayment and remortgage.

Early Repayment Charge cost:

ERC = L * ERC_rate

Calculate the instalment of the new mortgage using the annuity formula:

(P_new) = ((L * r_new)/12) / 1 - (1 + r_new / 12) -n_new * 12

Calculate the total cost of the new interest:

Cost of new interest = P_new * n_new - L

And the total cost of remortgage:

Total refinancing cost = Cost of new interest * ERC

Finally, compare the two options. If the cost of staying on the old mortgage (I_old) is** greater** than the total cost of refinancing, it pays to pay the ERC and take out a new mortgage. If not, it is better to stay on the current mortgage.

Summary

Because of how complicated the calculations can be, you should consult your mortgage broker regarding the Early Repayment Charge. This is a very important detail in the context of possible mortgage overpayments as well as the possibility of doing a refinancing.

It is worth being aware that, as with commission, the amount of the Early Repayment Charge is a cost that needs to be factored into the calculation of the profitability of the mortgage. Sometimes it is better to take a mortgage with a higher interest rate but a lower ERC, and in other cases it is better to sacrifice the interest rate in favour of a low ERC and commission.