Was Removing Exit Fees a Good Idea?

For many years banks and financial institutions have levied exit fees on their mortgages.  Recently these fees have been outlawed, but is this a good thing for competition like many people are saying?

Loan exit fees were often significant, and were generally charged if the loan was paid out within the first few years  of the loan (commonly 3 or 5 years).

Many consumer groups and borrowers believed that the exit fees were leading to a reduction in competition in the mortgage industry, as borrowers were no able to freely move from one bank to another in search of a better deal.

As of 1 July 2011 exit fees have been banned on all new mortgages, and The Commonwealth Government is currently advertising this fact heavily through the television ads which claim the ban will increase competition.

What was the purpose of exit fees?

Another name for an exit fee is a ‘deferred establishment fee’.  When a borrower takes out a new loan there are considerable costs to the lender in terms of the work required to get the loan up and running.  With many loans having an establishment fee of around $500, this amount was not sufficient to cover the lender’s actual costs.

Of course over time the lender would make that money back, along with a lot more, but this may not happen for the first couple of years.  If a borrower paid out their loan within that period, there was potential for the lender to actually make a loss on the loan.  Therefore the exit fee – or deferred establishment fee – was charged to recoup the loss.

What were the alternatives to exit fees?

One option available to the lenders was to increase the establishment fee to an amount sufficient to cover their costs, which would not have been welcomed by customers.  Another option was to increase interest rates to ensure they made more money on the loans in the first few years, but again this would not have been popular with customers.

The third option was to simply risk losing money on any home loans which were repaid within the first few years.  With the introduction of the ban on break fees, this has been the way that most lenders have gone.

What are the consequences of the ban?

Customers will be free to switch from lender to lender in order to chase a better rate.  The lowest rate will often swap around from one lender to the next.

This means that customers are more likely to switch their home loans more often, which will lead to increased work by the lenders.  The lenders cannot charge an exit fee now, and they are unlikely to increase their establishment fees, so it results in greater costs to the lenders in terms of processing.

So how could this have a negative effect on competition?

At first glance it’s easy to think that this ban will lead to more competition for the big banks, but many in the industry believe that the opposite is true.

The ban on exit fees will lead extra work for lenders without any extra income.  For the major banks with many thousands of staff, it won’t be difficult to absorb this extra work without being financially impacted.

For a non-bank lender with a much smaller number of staff trying to offer great rates, the extra workload could lead to needing extra staff. But extra staff will lead to extra costs, and extra costs will take away their ability to offer lower rates.

If the non-banks cannot offer the rates that consumers are looking for, their customers will simply swap back to the banks.  This could lead to a decline in non-bank lending, which would then lead to a decline in competition as the banks simply increased their dominance over the market.

What happens now?

The non-bank players have usually been the most innovative in the mortgage industry in Australia, and to remain competitive in the face of the Government’s bans they will need to be even more innovative to ensure they can still offer low rates whilst dealing with potentially higher costs.

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