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Early redemption penalty
If you want to terminate a mortgage early, you will have to pay an early redemption penalty. Read about when this applies, how it is calculated, and whether it is tax-deductible.
Content:
The five-year, fixed-rate mortgage used to be the most popular mortgage product in Switzerland. Today, the trend is moving towards mortgage terms of ten years or more. Many home buyers are primarily concerned with playing it safe with their money. Their main priority is a fixed interest rate. But what would happen if you needed to terminate the mortgage unexpectedly?
When faced with divorce or a move away for work-related reasons, many property owners may wish to terminate their mortgage early. The same is true in the case of unexpected events or misfortunes such as prolonged unemployment, serious illness, disability or the death of a partner.
“Early redemption penalty” is the key term in this scenario. This is a fee that is incurred when a mortgage or loan is terminated or repaid early. Its purpose is to compensate the bank for the interest income lost and costs incurred. Depending on interest rate levels, an early redemption penalty can be positive (in favor of the bank) or negative (in favor of the borrowers).
In mortgage agreements and general terms and conditions, certain rules of play apply in these scenarios because terminating or paying off a mortgage early ultimately poses some tricky questions. Are there provisions for this in the mortgage agreement? And if so, how quickly and under what conditions would a customer be released from the loan agreement?
Since the bank originally refinanced the mortgage on a long-term basis, it is entitled, in accordance with established case law, to demand compensation in the event of the mortgage loan being terminated early. The exit costs are always based on the interest rate differential:
An early redemption penalty is always payable when a mortgage is terminated early. There may be various reasons for this:
Every lending institution calculates the penalty differently and applies various parameters. However, an early redemption penalty is generally calculated based on some established components. In particular, the remaining term of the mortgage – the longer it is, the higher the potential penalty will be. Factors such as the interest rate of the existing mortgage or the current interest rate that banks can achieve in the market for a comparable investment period at the time of termination are also crucial. This results in the interest rate differential, which is multiplied by the remaining term and the mortgage amount. Banks usually charge additional administrative and processing fees.
In our hypothetical example, the borrower wants to terminate the mortgage three years before it expires. The mortgage was originally CHF 500,000.
Item | Item | Amount | Amount |
|---|---|---|---|
Item | Mortgage amount | Amount | CHF 500,000 |
Item | Interest rate on fixed-rate mortgage | Amount | 2% |
Item | Interest rate for reinvestment in the capital market | Amount | 1% |
Item | Difference in percent per year | Amount | 1% |
Item | Total difference for the remaining 3-year term | Amount | 3% |
Item | Exit penalty | Amount | CHF 15,000 |
Item | It should be noted that the calculation of the early redemption penalty is only valid on the day it is calculated. | Amount |
The early redemption penalty essentially depends on three factors:
In individual cases, it is not easy to calculate the early redemption penalty to which the bank is entitled. It depends on the wording of the mortgage agreement and the general terms and conditions. In practice, only experts can assess what the realistic reinvestment rate might be on any given date.
The situation becomes even more complex if a borrower wishes to pay off or terminate several tranches with different terms early.
The standard industry practice of compensation applies regardless of what prompted the customer to terminate the mortgage early. Sometimes, the desire to pay off a mortgage early arises because interest rates have fallen since the agreement was signed. In these cases, property owners should only pay off the existing mortgage if the interest savings exceed the early redemption penalty. ۶Ƶ experts can advise homeowners who are thinking about paying off their mortgage early and provide support every step of the way. Learn more about switching options here.
Not every early termination automatically entails a penalty. It also depends on the type of mortgage you have taken out. For example, a fixed-rate mortgage , which has a predetermined interest rate and a defined term, does not allow for early termination. If you still want to do so, you should generally expect that compensation may be due. Some lending institutions do allow exceptions here, such as in the case of death.
Variable-rate mortgages usually have a very short term of a few months. The mortgage can be terminated at any time, but the notice period must be observed. A penalty does not usually apply in this case.
The principle whereby banks must receive compensation for refinancing and lost interest also applies to SARON mortgages. However, these products are much more flexible in this regard. Consequently, the customer has the right to switch from a SARON mortgage to a fixed-rate mortgage from the same provider at all times, and to do so free of charge.
Incidentally, the SARON mortgage from ۶Ƶ mortgages is subject to a 13-month notice period. If a customer wants to pay off or terminate their mortgage even sooner, they must pay compensation in accordance with the aforementioned rules, the only difference being that, for this comparatively short remaining term, the outstanding amount is usually not too high. If flexibility is important to you, you should incorporate SARON mortgages into your strategy.
Obtain an overview of mortgage models and find out which one is best for you.
In recent years, fixed-rate mortgages with long fixed interest rates have proven to be extremely popular. The vast majority of customers want to secure their budget with low-cost, fixed-rate mortgages for as long as possible. However, in the case of very long-term agreements, this could mean the early redemption penalty is high. Despite this, in practice the following constructive solutions exist.
If a homeowner is forced to sell, for example after a divorce, it may be worth talking to the future owner. Instead of terminating the mortgage early, it may be possible to transfer the mortgage to the buyer. Of course, both the new owner and the bank must agree to this. If the interest rate on the mortgage in question is higher than current mortgage offers, it would be fair to agree some form of compensation.
A second alternative is to transfer the mortgage to another property. Let’s assume a property owner is moving from Basel to St. Gallen for work reasons and acquires another residential property in their new place of residence. The mortgage “moves” too. This scenario is not so simple from an administrative and legal perspective, for example, issuing promissory notes. In principle, however, it is a good idea to negotiate with the bank on transferring the mortgage to your new home.
Can the early redemption penalty be negotiated? Perhaps, but all lawyers unanimously agree on the binding nature of contracts (pacta sunt servanda). In practice, the bank will take individual circumstances into consideration. For example, it makes a difference whether the follow-up financing after this extraordinary termination is with the same bank or not. The bank must also take cases of exceptional hardship into consideration.
Finally, the question arises as to whether an early redemption penalty is deductible from taxable income in the same way as interest on debt. Reminder: Under Swiss tax law, every homeowner is entitled to deduct private debt interest (including mortgage interest) from their taxable income, up to the amount of property income plus CHF 50,000.
In legal terms, however, it would be too simple to just add an early redemption penalty to the debt interest. According to a landmark federal court ruling, an early redemption penalty is only deductible if the customer takes out a new mortgage with the same bank. In other words, there must be a connection with the original mortgage.
It is a different scenario if a customer terminates a mortgage because they wish to sell the house unencumbered (i.e. without an ongoing mortgage). According to case law, an early redemption penalty is not deductible from income in this case. However, these costs are considered as an expense by the owner and are therefore included in the investment costs. These, may then be deducted when calculating any taxable gain on the property.
When entering into a mortgage contract, property buyers should examine various aspects and find the solution that suits them best. This includes not only the interest costs but also the contract terms and, in particular, the provisions under the “extraordinary termination” section. Dealing with the issue of early redemption penalties before concluding a mortgage can help you avoid unpleasant surprises later on.
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