What Is a Breakage Cost?
When a certain loan product is issued by some financial institution, there is an interest rate tied to the repayment of the debt. Often, these interest payments are included in budgets and other financial plans of the lender. In the event that a borrower repays a lender for a debt that is structured as a fixed loan early, a breakage cost will typically be assessed. This is the penalty that must be paid by the borrower to the lender for violating the terms of the agreement and repaying the debt before an expiration date. It is also possible that breakage cost refers to an amount paid by a product supplier to a customer to cover damage that might occur to items, such as inventory, during transportation.
When taking out a loan, such as a home mortgage, it is possible to obtain a fixed rate of interest. With this type of loan, a borrower knows precisely what the monthly payments will amount to. In order to make the loan possible, a lender may need to borrow capital from the financial markets in order to obtain the fixed rate of interest. If a borrower decides to refinance a loan or pay the debt prematurely, the lender is likely to be charged a breakage cost for not fulfilling the terms of that agreement. Those charges are subsequently passed on to the borrower.
Banks adhere to some formula for issuing a breakage fee. This cost may be assessed by determining the total value of interest payments in the fixed loan over one quarter's time. If a refinancing is taking place, the breakage cost may be determined by calculating the difference between interest that is due on both loans. It is likely the bank will charge the higher of the two possible scenarios if applicable.
The borrower inherits risk when taking on a fixed loan, and these factors should be outlined in the terms of an agreement when the fixed loan is issued. A financial institution may have a policy to issue a breakage cost to a customer for disrupting an agreement based on all of the interest that would have been paid if the loan were not terminated early. As a result, the lender does not lose any money and the borrower remains responsible for the original terms even with an early repayment. A lender may insist that its other financial commitments must be honored despite a borrower's change in circumstances.
@miriam98 - Well, don’t assume anything. Check out the terms of the agreement. The article suggests that the breakage cost is assessed to the lender and they pass it on to the borrower.
So I don’t know that the lender has a lot of control in these areas. They’re getting hit with the fee themselves. My advice is just to read all the fine print regardless of what loan you take out.
@Charred - I think you’re correct. In the early days of mortgages, banks were a little more rigid about prepayment terms. Then the so called financial gurus came out with their “secrets” of how to save hundreds of thousands of dollars on your home mortgage by prepaying it, either through adding an extra payment each month or whatever.
As this became more common knowledge banks became more flexible in their payment arrangements. I think another factor that has contributed to this is the high foreclosure rate during the bust cycle of the real estate market.
Banks would rather have less money in interest than no money in interest, and so they became more flexible in my opinion.
I don’t know how common the break cost is as applied to home mortgages honestly. We bought our first house and paid it off within ten years. We incurred no penalties, at least none that I was aware of.
Of course when we took out the loan the lender made it clear up front that there was no penalty for early prepayment of the loan. The same was true for the mortgage on our second house.
We were told that we could prepay it without incurring a breakage cost (or penalty). I think years ago the penalties were more common but lately the lenders have become more flexible, from what I can tell.
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