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Break Costs

Updated on June 3, 2024
Article byNanditha Saravanakumar
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

Break Cost Meaning

Break costs typically refer to the cost incurred by a borrower when they repay or terminate a fixed-rate loan or mortgage before the end of its agreed term. The primary purpose of this fee is to indemnify the bank’s loss when the borrower repays early.

Break Costs

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The fee is charged as the bank borrows at wholesale interest rates from the money market to lend to its customers. However, banks set a prepayment threshold until customers can pay over the regular interest amount. Exceeding this threshold at any time over the payment period will incur break costs. To compensate for this loss, lenders may charge break costs to borrowers.

Key Takeaways

  • Break costs are the charges levied by banks when borrowers pay their loan before the end of the payment period or switch the loan product. 
  • These charges are levied to compensate for the loss incurred by the lender due to the early repayment of the loan.
  • However, borrowers need to know the potential costs when considering early repayment. 
  • Here, the lender losses the interest income they would have earned if the loan term had continued longer.

Break Cost Explained

Break costs are one of the many fees charged by banks and other lending institutions. The objective of such a charge is to protect the lender‘s financial interests. Moreover, the average break costs can be fixed or variable depending on the loan or mortgage terms. Hence, fixed loan break costs are designed to compensate the lender for the financial loss they incur due to early repayment.

As a result, this loss of income can be significant significantly, if the market interest rates have fallen since the loan or mortgage was taken out. Hence, the average break costs charged depend on several factors, including the remaining term of the loan or mortgage, the interest loan on the loan or mortgage, and the prevailing market interest rates.

For instance, if a borrower has a fixed-rate mortgage with an interest rate of 4% and agrees to repay the mortgage early when the market interest rate has fallen to 2%. To this, the lender may charge the borrower fixed loan break costs to compensate for the lost income they would have earned at the higher interest rate. Therefore, these charges are also seen in the lease agreement between the lessee and the lessor. Hence, break costs in the lease can be significant significantly if the market conditions have changed since the lease was signed.

Besides, it is essential to note that the actual costs can vary widely between borrowers and can only be determined by the lender or lessor. Hence, it is advised that borrowers and lessees should carefully review the terms of the loan, mortgage, or lease agreement. Thereby, are consult with their lender or lessor to comprehend the specific break costs that may apply to them.

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Formula

The formula for calculating these costs for a loan or mortgage can vary depending on the specific terms of the loan or mortgage agreement. However, break costs can be calculated using this formula:

Break costs = Interest rate differential * Remaining loan balance* Remaining term

  • The interest rate applies to the bank’s borrowed sum. The rate applicable for the remaining payment period should be less than the rate applied at the beginning.
  • The remaining term is calculated in years.
  • The average loan balance is taken as on that particular date had the prepayment or switched not been made.
  • The product is then adjusted to inflation and that particular day’s value in dollars.

However, it is essential to remember that these calculations can be complex and require more than merely employing the basic formula. Also, customers can make use of the break costs calculators available online. Nevertheless, it is always better to get a quote from the lender.

Calculation Example

Here’s a simple calculation example.

Suppose Amy has a $500,000 fixed-rate home loan with a remaining term of 3 years and an interest rate of 0f 4.5% per annum. She wishes to terminate the loan early, and the current market interest rates for a similar loan are 3.5% per annum.

Firstly, determine the outstanding loan balance during early repayment or termination. Hence, let’s assume the outstanding loan balance at early repayment is $400,000.

Next, calculate the interest rate differential. The interest rate differential is calculated as 4.5%- 3.5%= 1%

Then multiply the outstanding loan balance by the interest rate differential. $400,000 * 1.0% = $4,000

Lastly, multiply the result by the remaining term of the loan, expressed in years $4,000* 3 = $12,000

Therefore, the estimated break cost for terminating the home loan would be $12,000

Break Cost vs Prepayment Fee

Fixed Loan break costs and prepayment fees are remarkably similar concepts. So, let’s study them in-depth.

Break CostsPrepayment Fees
Charged when a fixed rate loan or mortgage is terminated earlyPrepayment fees are charged when a borrower makes extra payments on their loan or mortgage to pay it off early
Designed to compensate the lender for lost interest incomeIt is intended to discourage early repayment
Can be significant and can vary depending on the specific terms of the loan or mortgage agreementThese can be a flat fee or a percentage of the amount being prepaid and can also vary depending on the particular duration of the loan or mortgage agreement
Typically applied to fixed rate loans or mortgagesThey apply to variable-rate loans or mortgages

Frequently Asked Questions (FAQs)

1. Do variable loans have break costs?

Yes. In variable loans, there is no fixed interest rate. But if the borrower repays the loan before the end of the payment period, variable loans, too, incur a loss for the bank, leading them to charge the fee.

2. Why do banks charge break costs?

Banks usually utilize customers’ deposits and credit from the money market to lend loans to customers. When banks resort to the latter, the market charges a wholesale interest rate, a liability to the bank. They repay the money market with the interest payments collected from the customers. When customers pay ahead, the interest payment reduces, and the banks lose their income. So they charge fixed rate break costs.

3. Are loan break costs taxes deductible?

The tax deductibility of loan break costs depends on the loan’s purpose and the borrower’s specific circumstances. However, if the purpose of the loan is for income–producing or investment purposes, such as a loan for a rental property or a business loan. In that case, these costs may be considered a tax-deductible expense.

This article has been a guide to Break Costs and its meaning. Here, we explain its formula, calculation, example, and comparison with the prepayment fee. You may also find some useful articles here –

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