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Break costs is a contract term that essentially refers to opportunity costs incurred by a lender for the funds loaned to borrowers due to a disruption in the amortization schedule as a result of events such as defaults, full redemption, partial prepayment, etc.
There is not standard method of calculating break costs across the lending industry and each lender determines how their break costs is defined. Some even call it by a different name.
The logic behind break cost is that when lenders commit a huge sum of money to homeowners to purchase new property or refinance old ones, lenders are willing to do so to make a profit in the form of interest charges.
And when certain events occur that result in the absence of projected debt repayments, then lenders are basically taking on a double hit on their loanable funds.
This is because not only are their funds not generating an interest from borrowers due to the lack of repayment, the same funds could have earned money if placed in other financial assets such as fixed deposits or treasury bonds.
Penalizing borrowers with a break costs item when the terms of the loan contract is breached helps lenders ensure that they can minimize their losses, even if it’s opportunity costs.
Some justified terms that can allow lenders to charge break costs on borrowers include:
- Cancellation of credit facility
- Full or partial repayment of principal, especially with fixed rate home loans
While there is no standard equation to calculate this figure, any formula that is fair to consumers usually consist of variables accounting for the costs of funds at the commencement of the facility and the costs of funds at the time the event had occurred.
A lot of home loans also do not indicate break costs in their facility letters. This is because it is already factored into the cancellation penalties and clawbacks.
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