Breakage cost

Breakage cost
See also
Sinkable bond Debenture Redemption Reserve Advance payment bond Automatic Premium Loan Cash and cash equivalents Yield maintenance Retention bond Memorandum account Reversionary bonus

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.

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.

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.

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.

Calculating breaking cost

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

• 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

If the mortgage loan has a breakage cost, it must be disclosed to the client before signing the contract. According to T. A. Durkin and other authors "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".

Examples of Breakage cost

• Early repayment penalty: This is the most common form of breakage cost, which is charged to a borrower who pays off their credit agreement ahead of schedule. This penalty is usually a percentage of the remaining loan balance and is used by lenders to recoup the loss of interest income they expected to collect over the remaining period of the loan.
• Prepayment penalty: A prepayment penalty is a fee charged to a borrower who pays off their debt early. This penalty is essentially a form of breakage cost and is used by lenders to discourage early repayment of loans and to ensure that they will collect the interest income they expected from the loan.
• Re-amortization fee: A re-amortization fee is a breakage cost that is charged when a borrower refinances their existing loan. This fee is usually a percentage of the remaining loan balance and is used to cover the administrative costs of refinancing the loan.
• Early termination fee: An early termination fee is a breakage cost that is charged when a borrower terminates their credit agreement before the end of the term. This fee is usually a percentage of the remaining loan balance and is used to cover the administrative costs of closing the loan.

Advantages of Breakage cost

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. The advantages of breakage cost include:

• It provides a financial incentive to borrowers to maintain the loan agreement and not pay it off before the agreed upon date.
• It can help to protect lenders against potential losses in the event of early repayment.
• It can help to encourage borrowers to make regular payments on time, thus avoiding defaulting on the loan.
• It can provide lenders with additional income from breakage fees, which can be used to fund other activities.
• It can be used to ensure that lenders receive a fair return on their investment, even if the loan is paid off early.

Limitations of Breakage cost

Breakage cost is a fee charged when the borrower makes a principal repayment before the date specified in the credit agreement. There are several limitations associated with breakage cost:

• The amount of breakage cost cannot exceed the amount of the principal that was prepaid.
• The breakage cost cannot be more than the amount of interest that would have been earned if the principal had remained outstanding until the due date.
• Breakage cost cannot be charged if the principle repayment is made after the due date.
• The breakage cost must be clearly stated in the credit agreement, and the borrower must be made aware of the cost before agreeing to the terms of the loan.
• Breakage cost cannot be applied to any other fees associated with the loan, such as late fees or penalty fees.

Other approaches related to Breakage cost

There are other approaches to determining the Breakage cost, such as:

• A penalty fee: This fee is charged to the borrower in case of a premature withdrawal from the contract.
• Lost interest: The borrower may be required to pay the lender the amount of interest that would have been earned had the loan been repaid as per the contract agreement.
• Early repayment fee: An early repayment fee may be charged to the borrower in addition to any other fees or penalties.
• Loss of reinvestment income: Lenders may require borrowers to pay for the loss of income that would have been earned had the loan been repaid as per the contract agreement.
• Deferred payment penalty: A deferred payment penalty may be charged when payments are delayed or missed.

In summary, Breakage cost can be a penalty fee, lost interest, early repayment fee, loss of reinvestment income, and a deferred payment penalty.

References

• Durkin T. A., Elliehausen G., Staten M. E., Zywicki T., (2014), Consumer Credit and the American Economy, Oxford University Press.
• Fabozzi F. J., Yuen D., (1998), Managing MBS Portfolios, John Wiley & Sons, New Hope.
• Haupt K. J., Rockwell D. L., (2006), Principles of California Real Estate, Rockwell Publishing, Bellevue.
• Reilly J. W., (2000), The Language of Real Estate, Dearborn Real Estate, Chicago.
• Schmudde D. A., (2004), A Practical Guide to Mortgages and Liens, ALI-ABA, Philadelphia.
• Stephens M., Burns N., MacKay L., (2002), Social Market Or Safety Net?: British Social Rented Housing in a European Context, Policy Press, Bristol.
• Vinter G. D, Price G, (2006), Project Finance: A Legal Guide, Sweet & Maxwell, London.
• Yescombe E. R., (2011), Public-Private Partnerships: Principles of Policy and Finance, Elsevier, Amsterdam.
• Yescombe E. R., (2002), Principles of Project Finance, Elsevier, Amsterdam.
• Zisman B. S., (2018), Banks and Thrifts: Government Enforcement and Receivership, LexisNexis.

Author: Fryderyk Olchawa