Nasar Zamir outlines the problems faced by borrowers when calculating break costs in commercial loans.
Many small and medium-sized enterprises rely on long-term borrowing for financing purposes. To protect against increases in interest rates one can fix the rate of interest so that interest rate costs are known for the duration of the loan.
However, if the borrower needs to refinance during the term of the existing loan because of changes in business circumstances they may suffer break costs. These break costs can be considerable – as much as 25% of the face value of the loan.
There have been numerous complaints by borrowers that the existence and magnitude of break costs in commercial loans were not fairly described by the lender at the point of sale. Even where disclosure of break costs has been explicit and detailed (meeting the regulatory tests for being fair and reasonable) there is little evidence that customers understand the mechanics of the calculation and what should be considered a fairly calculated break cost.
Standard approach
The standard approach used by many banks to arrive at a break cost value is to consider the “present value” (using discounted cash flow techniques) of the remaining fixed cashflow obligations of the borrower (including lender’s margin), less a current “market rate” (derived from an interest rate swap which matches the tenor and notional profile of the outstanding loan on the unwind date).
The lender’s margin incorporated into the calculation would typically include not only credit risk and funding costs but also bank profit.
As an example, a customer may ask the bank for a break cost quotation on his fixed rate loan which has £500,000 maturing in January 2026. The loan carries a fixed rate of 4.45% which consists of 0.54% lender’s margin i.e. 3.91% exclusive of margin. The bank quotes the break cost as £148,000. However, if the margin was excluded the break cost would be £125,000 - a difference of £23,000!
This £23,000 is a charge the bank is making to compensate it for losing its margin over the years up to 2026. But typically the borrower will be restructuring his business finances and will require a new interest rate protection product, and you can be sure that the bank will include its margin in that new product too.
My experience is that most borrowers have little understanding of the break cost methodology and are ill-equipped to validate or challenge the figure provided by the bank.
A number of different calculator products are available on the market to assist customers in determining the fair value of their financial product, and if customers believe they have been mis-sold a fixed-rate loan they can first complain to the bank, and if necessary the Financial Ombudsman Service for resolution.