Breakage cost

Breakage cost
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Methods and techniques

Breakage cost is some amount determined when the credit agreement is charged to the borrower for making payment of any principal repayment before the date which is specified in the contract[1].

Breakage cost occurs if the borrower repays the principal loan before the last day of the interest period, banks may to suffer a loss because they bear interest on the interbank loan. The lenders must protect themselfves against the breakage costs[2].

To avoid breakage cost some housing cooperatives retain debts on one side of their balance sheets, while keeping the investment subsidy. The purpose of this activity is to strengthen the cooperative's balance sheets so that the government will stop subsidizing the sector[3].

Breakage cost can be also called as pre-payment penalty. Prepayment penalty cause inhibition of ability to prepay the loan. Investors and creditors used this penalty to manage the risk of loan prepayment by charging fees, if the loan has been repaid before the due date. In exchange for keeping the terms of the agreement, the lender offers lower interest rates at the time of signing the contract[4].

Calculating breaking cost[edit]

Calculating breakage cost of the inflation-indexed loan is by[5]:

  • Taking the stream of future real payments.
  • Inflating payments by the implied inflation rate for the remaining loan time.
  • Discounting payments at the current market rate constant for the remaining loan time.

Breakage cost in mortgages[edit]

If the mortgage loan has a breakage cost, it must be disclosed to the client before signing the contract[1]. According to T. A. Durkin and other autors "The Dodd-Frank Act (sections 1414 and 1432) prohibits prepayment penalties for mortgages that ale 'not qualified' mortgages and also significantly restricts application of prepayment penalties to qualified loans"[4].

Footnotes[edit]

  1. 1.0 1.1 Zisman B. S., (2018), Banks and Thrifts: Government Enforcement and Receivership, LexisNexis.
  2. Vinter G. D, Price G, (2006), Project Finance: A Legal Guide, Sweet & Maxwell, London, p. 177
  3. Stephens M., Burns N., MacKay L., (2002), Social Market Or Safety Net?: British Social Rented Housing in a European Context, Policy Press, Bristol, p. 39
  4. 4.0 4.1 Durkin T. A., Elliehausen G., Staten M. E., Zywicki T., (2014), Consumer Credit and the American Economy, Oxford University Press, p. 410.
  5. Yescombe E. R., (2011), Public-Private Partnerships: Principles of Policy and Finance, Elsevier, Amsterdam, p. 196

References[edit]

Author: Fryderyk Olchawa