Fixed rate loan - why do banks make it hard to deposit extra?

Hi PC crew,

Kind of a shower thought:
I'm keen to understand why some banks make it difficult to deposite more into fixed rate loans.
At face value, I just don't understand the limitations that are in place, especially when the fixed term rates are usually higher than variable.

For example NAB allow a max of $20,000 extra repayments into fixed loans for the duration of the fixed period.

My question is whether this is standard fare for lenders, either major and lower tier? Do some lenders offer more freedom with being able to pay extra into fixed loans, and be able to redraw it prior to the fixed term ending?

Keen to get your views or experience.
Thanks

 

The NABs approach is common place. A couple of lenders are more flexible with extra repayments on fixed loans, but that's rare.

Think of fixed rates as follows:
* The bank buys the money from an external source at a particular price for a given period of time. Their cost of the money for that period is fixed.
* The rate you pay is effectively the price your bank pays for that money, plus a mark up (the bank's profit).
* If you make extra repayments, the bank won't make a profit, so they penalise you for extra repayments.

The bank expects to make a certain margin on the loan during the fixed period. You get the certainty of knowing exactly what the repayments will be regardless of what the market does (for better or worse). In return, the bank expects to make their margin.

 

Great explanation. Thanks Peter.

 

I used to work in a major bank treasury and saw this operate. It seems so complex but is a relatively simple issue.

Banks balance all fixed loans with a financial markets swap contract on their books and dont "carry" a risk as a way to speculate on market rate movements. Its just like a bookie who lays-off his bet. APRA doesnt let them speculate on terms and market mopvements. They MUST hedge based on actual costs. Bank loan books must be hedged for the same term so that risk isnt accumulated. (imagine a bank with a multi billion dollar deferred debt !! Wipeout !! ) So when a loan is written or its broken the bank is merely locking in the spread (profit margin). So when you break a loan they have to break their swap deal. Literally on a loan by loan basis - They actually aggregate them every few days)

Contrary to belief bank dont "borrow" from depositors. They borrow from markets for the same terms as the loan book ie 1,2, 5, 10 years. The underlying markets are bank bills for short term and also futures markets as well as 10yr semigov and treasury bonds. Some are securitised but its all same market.

So you compensate them if they face a penalty etc. eg
They lend to you at 7.5% and you break it to a 5% variable rate which still has say 15months. You owe then 2.5% for the remaining term. The longer the deal the more you pay. They then discount that penalty for the present value of money which is cheap now at 4.5%+ for variable.

 

Just to add to what Paul has said, Bank's don't hedge absolutely 100%. They are able to estimate with a fair degree of accuracy the "prepayment risk" inherent in the loan book - the risk that some borrowers will in fact pre-pay their fixed loans and/or refinance. So a very small portion the leave unhedged, but it is still a source of P&L volatility that cannot be entirely eliminated.

Of course some banks do this better than others, and it partly shows up when you hear about "hedging ineffectiveness" in a Bank's results presentation.