Enforceability of break fees

[boomtown]

It is a fundamental concept of Australian contract law that penalties are not enforceable at law. That is why break fees for termination of a fixed rate mortgage are called liquidated damages in the contract.

Simply put the calculation for a break fee is fixed interest rate less wholesale rate times years remaining on the fixed loan.

However the break fees when calculated by banks invariably use a wholesale rate that is lower than the rate any punter can get when depositing those funds. I have seen break fees approaching the total value of all interest payments payable under the loan for the remainder of the life of the loan. This is purely the banks taking the ****.

Accordingly by using that wholesale rate the bank is not complying with its common law obligation to mitigate its damages and the so called liquidated damages / break fee are in fact a penalty under Australian law and unenforceable.

Happy for anyone to disprove my point that the banks are acting illegally in calculating mortgage break fees.

The correct calculation should be (at worst) fixed rate less bank deposit rate times years remaining on the loan.

 

[Rolf Latham]

ummmmmmmmmmmmm

just my view.

I aint no silk, and just using common place expectations.

If I borrow money at x and take a contract to do so, and onlend that money to you at y, and you bust your contract with me half way through, you expect me to hold the can between my lender and me ?

I dont disagree with ur sentiment that these transactions are as transparent as muddy swamp water...............but I have trouble seeing they would be "illegal", the Slater Gordons of the world would have been ALL over it by now

ta
rolf

 

[Scott No Mates]

The bank has an expectation that the loan will run its term and in return get $x interest over the fixed period. You enter into an agreement to pay that interest. The bank has a commitment to its source of funds for the term of their loan. It is not a difficult concept to grasp.
Just like your phone provider will say upfront that your payout figure is X months x your monthly fee.

 

[Belbo]

Scott & Rolf,

I think you are missing the very valid point Boomtown is making. The banks accept that the break fee has to be the foregone income less the income they can now make from the release funds. But they discount the latter unfairly.

 

[boomtown]

As you guys would be aware there is currently a class action against the big banks for charging fees (such as a $30 dollar fee for dishonoured cheques or overdrawn accounts) where the size of the fee far exceeded the costs ("damages") to the bank of processing the dishonoured cheque.

I think the class action has good odds of getting up (and apparently so does the firm running it).

To me break fees as currently calculated are exactly the same. The bank is levying a fee (expressed as damages) when its true damages are much lower.

I am not disputing that the bank has a contractual right to charge its damages for early termination. But we can all agree that the bank should not have the right to charge a million dollars to break a thousand dollar loan.

Under the common law this is adressed by the common law duty to mitigate damages. It is quite clear to me that the banks are not doing so and it is hugely profitable for them to do so.

It also means a massive financial exposure for them in case of anothert class action.

 

[Rolf Latham]

As you guys would be aware there is currently a class action against the big banks for charging fees (such as a $30 dollar fee for dishonoured cheques or overdrawn accounts) where the size of the fee far exceeded the costs ("damages") to the bank of processing the dishonoured cheque.

I think the class action has good odds of getting up (and apparently so does the firm running it).

To me break fees as currently calculated are exactly the same. The bank is levying a fee (expressed as damages) when its true damages are much lower.

I am not disputing that the bank has a contractual right to charge its damages for early termination. But we can all agree that the bank should not have the right to charge a million dollars to break a thousand dollar loan.

Under the common law this is adressed by the common law duty to mitigate damages. It is quite clear to me that the banks are not doing so and it is hugely profitable for them to do so.

It also means a massive financial exposure for them in case of anothert class action.

I do think its worthwhile to get some actual examples to air here from folks that have have actually had to or chose to break loans, so from a real life perspective, rather than working with back of the "envelope numbers".

My business experience tends to suggest that the bigger the lender, the lower the actual sting..........................and the smaller the lender, the higher the relative exit cost.

But, lets have some real examples folks.

I will dig through my archives

for the data to be useful we would need

Amount of loan
rate fixed at
period fixed for
period of loan left to run in days
actual prepayment or ecnomic loss paid ( not fluffy stuff like mortgage disch fees, admin break costs, early loan break fees not related to the fixed rate etc)

ta
rolf

 

[Belbo]

You'd also need the break date Rolf, as that would determine the relevant wholesale rate, right?

 

[Rolf Latham]

You'd also need the break date Rolf, as that would determine the relevant wholesale rate, right?

Like yeah that would help a lot

But wholesale rate isn't what the money was bought for........

Ta
rolf

 

[Belbo]

Like yeah that would help a lot

But wholesale rate isn't what the money was bought for........

Ta
rolf

But it's what it could be re-lent for. Doesn't this go to the crux of the issue?

 

[Rolf Latham]

But it's what it could be re-lent for. Doesn't this go to the crux of the issue?

No

Look at my simple example above

My economic loss was made when I paid my lender

I can't relend that money, and even in the scenarios where it can be relent, the cost of my relending that dough needs to be considered etc.

I'm not a treasury guy, nor do I know the detail workings behind the scenes, but my examples will likely hold true with secritised funds, but may be rubbery with on balance sheet lending.

Obviously as a broker it would be nice if I could get a client out of huge break cost and move them onto a new product, so I have my conflict of interest in this discussion.

I know there are big end of town finance folks on somersoft, so maybe they can chime in

Ta
rolf
Ta
rolf

Ta
Rolf

 

[Token Funder]

It is a fundamental concept of Australian contract law that penalties are not enforceable at law. That is why break fees for termination of a fixed rate mortgage are called liquidated damages in the contract.

Simply put the calculation for a break fee is fixed interest rate less wholesale rate times years remaining on the fixed loan.

However the break fees when calculated by banks invariably use a wholesale rate that is lower than the rate any punter can get when depositing those funds. I have seen break fees approaching the total value of all interest payments payable under the loan for the remainder of the life of the loan. This is purely the banks taking the ****.

Accordingly by using that wholesale rate the bank is not complying with its common law obligation to mitigate its damages and the so called liquidated damages / break fee are in fact a penalty under Australian law and unenforceable.

Happy for anyone to disprove my point that the banks are acting illegally in calculating mortgage break fees.

The correct calculation should be (at worst) fixed rate less bank deposit rate times years remaining on the loan.

Nope.

Break costs are an estimate of the economic loss brought about by terminating the fixed rate early.

To take a simplified example:

• You want a three year rate at, say, 7%.
• I am raising three year term deposits sits at 5%
• I lend to you at 7% by borrowing from my depositor at 5% and we all lock in in for three years.
• Happy days.
• As a result of falling rates, after two years of interest rate certainty you decide that the downside of a fixed rate is interest rate certainty and want out.
• My depositor loves interest rate certainty and wants to stay.
• When I let you break our deal, I am left with what amounts to a 1 year (3-2) term deposit with my depositor at 5%.
• Trouble is, as a result of those falling rates that encourgaed you to move in the first place, today I would only have to pay, say, 3% for aone year term deposit.
• My cost, therefore, is the remaining term (1year) at the difference between what I am obliged to pay my depositor and what I would be paying had you not reneged (2%)

 

[Rolf Latham]

Nope.

Break costs are an estimate of the economic loss brought about by terminating the fixed rate early.

To take a simplified example:

• You want a three year rate at, say, 7%.
• I am raising three year term deposits sits at 5%
• I lend to you at 7% by borrowing from my depositor at 5% and we all lock in in for three years.
• Happy days.
• As a result of falling rates, after two years of interest rate certainty you decide that the downside of a fixed rate is interest rate certainty and want out.
• My depositor loves interest rate certainty and wants to stay.
• When I let you break our deal, I am left with what amounts to a 1 year (3-2) term deposit with my depositor at 5%.
• Trouble is, as a result of those falling rates that encourgaed you to move in the first place, today I would only have to pay, say, 3% for aone year term deposit.
• My cost, therefore, is the remaining term (1year) at the difference between what I am obliged to pay my depositor and what I would be paying had you not reneged (2%)

I knew someone could simplify it for me

ta
rolf

 

[boomtown]

[*]My cost, therefore, is the remaining term (1year) at the difference between what I am obliged to pay my depositor and what I would be paying had you not reneged (2%)

I accept your calculation but that is not how it has actually worked for many people on this forum. Deposit rates soared during the GFC but so did the cost of break fees. On your calculation as deposit rates soared from per GFC levels break fees should have been minimal. Instead I was offered a break fee that approached the total value of all interest payable under the loan. I accept it may have been a particular characteristic of the lender (Wizard) whose book was being wound up at the time. *******s .

I will try to dig up the actual numbers but won't have access to the papers for a week or so.

 

[Aaron_C]

I accept your calculation but that is not how it has actually worked for many people on this forum. Deposit rates soared during the GFC but so did the cost of break fees.

That's because home loan rates fell during the GFC...hence the gap between the current mortgage rates (6% at the time) and what people were paying on fixed loans (8-9%) was even wider than before.

 

[Rolf Latham]

I accept it may have been a particular characteristic of the lender (Wizard) whose book was being wound up at the time. *******s .

I will try to dig up the actual numbers but won't have access to the papers for a week or so.

Ding

securitised funding

double hit there

ta
rolf

 

[boomtown]

Ok let's do an actual example (using round numbers for simplicity).

100k loan.

3 year term locked at 9% reverting to SVR at maturity.

Deposit rates are 6.5% for a one year fixed term.

Borrower breaks at exactly 24 months into the term (12 months remaining).

So long as the borrower pays the net present value of 2.5% on 100k for 12 months plus admin fee that should be it. It's irrelevant that it's securitized the funds go straight to the term deposit, the borrower tops it up to the fixed rate and it's like nothing has changed from the bank's perspective.

Why does this not work is way then?

 

[Rolf Latham]

Ok let's do an actual example (using round numbers for simplicity).

100k loan.

3 year term locked at 9% reverting to SVR at maturity.

Deposit rates are 6.5% for a one year fixed term.

Borrower breaks at exactly 24 months into the term (12 months remaining).

So long as the borrower pays the net present value of 2.5% on 100k for 12 months plus admin fee that should be it. It's irrelevant that it's securitized the funds go straight to the term deposit, the borrower tops it up to the fixed rate and it's like nothing has changed from the bank's perspective.

Why does this not work is way then?

I will leave the detail stuff to the specialists : )

a lot of the securitised loans had a hefty break fee associated with getting out early,

Notables we ere RAMS and Macq and Ge in and abive the 2 % mark

ta
rolf

 

[Token Funder]

Ok let's do an actual example (using round numbers for simplicity).

100k loan.

3 year term locked at 9% reverting to SVR at maturity.

Deposit rates are 6.5% for a one year fixed term.

Borrower breaks at exactly 24 months into the term (12 months remaining).

So long as the borrower pays the net present value of 2.5% on 100k for 12 months plus admin fee that should be it. It's irrelevant that it's securitized the funds go straight to the term deposit, the borrower tops it up to the fixed rate and it's like nothing has changed from the bank's perspective.

Why does this not work is way then?

You need to know what the three year funding cost on settlement was.

If cost of money for the remaining period is equal to or higher than at settlement, then arguably there is no economic loss, though there would be other costs which could and would apply.

Break costs don't include presumed profit margin, as your example would seem to imply.

As an aside, the example I provided earlier is a simplified one and could just as validly use costs of wholesale money at the relevant times as use deposit rates.

 

[tom32]

I think then from what Token Funder is saying, break fees are based on the old Robinson v Harmon simple notion; one must be put back in the same position as they would, so far as money can, should the contract have been performed fully. This as opposed to the mitigating costs idea.

This makes sense because the bank is entitled to certain profit (it is possible a certain loss) when it locks someone in to a loan. If they can find borowers to substitute at a higher interest rate at the time someone breaks contract then they have suffered no damages so then there would be no claim. If they cannot find a substitute borrower at the time of a break at a higher rate then the bank has suffered damages.

I guess in simple terms the break fee is not calculated on wholesale money deposits, bonds or anything else on the funding side but on the rate at which the borrower has signed up compared to what a new borrower at the time of the break would be prepared to sign up at. This is their obligation afterall. Nothing at all to do with funding rates.

So sure they can find cheaper funding but they would have done this anyway even if you were paying 10% interest and they could find deposits at 3% a year later. This is yippee for the banks and why should you be able to break when you made a commitment at the higher rate? They are entitled to this margin when you signed up at 10% in the first instance.

Mitigating the banks losses (and by extention the party in breach) would only come into it as I see it if the banks wanted to claim more than the face value entitlement under the contract. i.e. say you did not pay your minimum monthly repayment last month (this is farcical to make it simple) and because of this breach the commonwealth bank failed because they were relying on this for their entire 30bn of overnight funds movement. Say it was meant to pay the overnight payroll of some critical pen pusher... Now they have a run on the bank and could claim as a result of the breach the defaulting borrower owes us our old market capitalisation of 100bn dollars. In this case I reckon the court would say, "hey I reckon you fellas could have played that a little better than that and mititgated your loss."

While that is a ridiculous example, real life examples of banks mitigating costs for a party who has breached their contract occur every day post defaults. The bank in these situations cannot just ride roughshot over borrowers and claim the loss after selling an asset to a cousin of the bank manager for a steal etc. They must follow process and ensure they have done what they can for their ex customer or find they cannot claim the difference as a valid debt if they are proven to have not mitigated the party in breach's costs by selling an asset for below its value.

Edit: my thoughts are based on how construction contracts play out rather than any specific knowledge of how banks operate, so rely on the above at your peril.