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The Costs of Borrowing
When negotiating a loan from a lender, you will typically receive a Term Sheet setting out the core terms. However, when the formal loan document is eventually produced, it will contain detailed and complex provisions that place liability on the borrower to compensate or indemnify the lender for things such as Break Costs, Increased Costs, and other costs, fees and expenses incurred by the lender during the life of the loan.
So what are these costs, and can a borrower challenge them?
Break Costs
A fixed interest rate allows you to lock-in an interest rate over a loan term (usually 1 to 5 years). This gives the borrower the certainty of knowing exactly what its repayments will be during the term of the loan, irrespective of whether interest rates change. The lender will, itself, borrow funds at the applicable wholesale market rate for the same term, in order to make the loan to the borrower. The lender therefore has an obligation of its own to pay the organisations in the market who have lent it that money, also at a fixed rate. The lender makes its profit by charging a higher margin to its borrower than the margin it is paying on the funds it has borrowed in the markets.
If a borrower under a fixed rate loan decides to make additional voluntary repayments, above those that the lender has specified, that ought to have the effect of reducing the term of the loan (and, consequently, the overall amount of interest the lender would otherwise have expected to earn over the duration of the loan). The same would apply if the borrower elects to repay the loan in full earlier than the scheduled maturity date. Some lenders may also offer borrowers the freedom to request to vary the interest rate on their loan, e.g. to change the initial fixed interest rate over to a new fixed interest rate or on to a variable interest rate.
In any of the above circumstances, the lender will need to break the funding arrangements it had in place with its own lenders. That will, in all likelihood, result in a loss to the lender if the wholesale market rate at the point at which that underlying loan is being broken is lower than the original wholesale market rate at the time the lender borrowed the funds to lend them on to its borrower. Rather than shoulder that loss itself, the lender will pass that on to its own borrower as a break cost.
So how are Break Costs calculated?
In very general terms, if the wholesale interest rate for the remaining part of the fixed interest term at the point at which the fixed interest rate period is being broken is lower than the original wholesale interest rate when the fixed interest rate period started, then a Break Cost will be charged.
Break costs can also apply to a variable interest rate loan (a loan where the interest charged on the outstanding balance fluctuates, based on an underlying benchmark or index that periodically changes). A variable interest rate loan will be subject to fixed interest periods, being periods of time (usually 1, 2, 3 or 6 months) over which that variable rate is effectively fixed so the interest charge for each interest period can be calculated.
A lender under a variable rate loan may incur break costs if the borrower repays or prepays a loan on a date other than the last day of an interest period. The cost will be the difference between the interest the lender should have earned during the interest period starting from the date the payment was received and ending in the last day of that interest period, and the interest the lender could have obtained from placing an amount equal to the loan repayment on deposit with a leading bank for the same period.
Can Break Costs be minimised?
If a borrower was planning to repay a fixed rate loan early, either in whole or in part, or to trigger any election given to the borrower in the loan agreement to to vary the interest rate on the loan, then that borrower should ask its lender to calculate the likely Break Costs payable, and to advise whether those could be reduced if the repayment or switch were made at an earlier or later date. Given that the wholesale interest rates change from time to time, the actual Break Cost amount can vary- sometimes significantly – from moment to moment.
With a variable rate loan, it is all about the timing of making any repayment or prepayment. If the borrower is in a position to control that timing, it can help manage its exposure to break costs by ensuring that the payment is timed to coincide with the last day of an interest period. Unfortunately, this is not always at the borrower’s discretion: the loan agreement may contain provisions requiring that any net proceeds from a disposal of assets, or from an insurance claim, be applied immediately on receipt in reduction of the loan, therefore giving rise to the potential for an exposure to break costs.
Increased Costs
As a separate concept to Break Costs, loan agreements from banks and other financial institutions will also include an Increased Costs clause, which passes on to the borrower the risk of any unforeseen increase in the costs for the lender in making the loan available. So what are these increased costs?
The main costs that a lender incurs in providing its loan are its funding cost, which for a bank will include the cost of complying with capital adequacy and liquidity requirements applicable to that loan. When calculating the margin to charge on a loan, the lender will take into account the cost of complying with the capital adequacy requirements in force at the time the loan is made. However, capital adequacy and liquidity requirements change over time, and the cost to lenders of complying with regulations imposed on them from time to time can be significant, and in the case of regulations yet to come into existence, an unknown criteria. If an unexpected cost arises during the term of the loan due to changes to the regulatory framework, it could eat into the margin the lender is charging on the loan and therefore reduce its anticipated profit.
The Increased Cost clause provides that if something happens by way of change in regulatory requirements affecting a lender after the date on which a loan agreement is signed and which either (a) raises the cost to that lender of making or maintaining its loan, or (b) reduces the amount receivable by that lender under the loan (including a reduction in the rate of return on the facility or a rate of return on the bank’s overall capital) which is attributable to that lender funding the loan (or its participation in the loan), then that Increased Cost must be borne by the borrower.
Do I have to pay these Increased Costs?
On the face of it, it seems harsh that capital adequacy provisions, designed to ensure the health and stability of a lender, could end up becoming the borrower’s liability. In theory, a borrower could request that any capital adequacy requirements known at the time the loan is made, but not yet in force, be excluded from the increased costs clause on the grounds that the lender can take account of any additional cost arising from that proposed new requirement in the margin to be charged at the time the loan is made. However, most lenders will resist any attempt to delete or amend the Increased Costs provisions in their loan documentation, and consequently the Increased Cost clause is another potential cost of borrowing funds that a borrower must shoulder.
Default interest:
In addition to the margin the lender will charge on the loan, lenders will usually include a higher default interest rate. If the borrower fails to pay any sum when due, the lender can charge the default rate on that overdue sum until such time as it is paid in full. If the lender makes demand for the full outstanding balance of the loan following the occurrence of an event of default, the default interest rate will then apply to that debt. As the debt will also include any unpaid interest that had accrued up to the point of default, the effect of charging the default interest rate on that consolidated debt will be for interest (at the default rate) to be charged on top of interest that had already accrued at the original margin.
Is default interest fair?
To be recoverable, default interest must protect a legitimate business interest, and should not be extravagant, exorbitant, unconscionable or penal, but rather a genuine attempt by the lender to reflect the increased cost to it of administering an enhanced credit risk and of being kept out of its money. The courts have on the whole upheld the ability of lenders to charge an increased interest rate following a default. The judges in Holyoake v Candy [2017] EWHC 3397 (Ch) commented that clauses providing for the entire balance of a loan to become payable following default were standard provisions in loan documents, and charging further interest on top of this sum was also standard practice, and not therefore something for the courts to overturn.
Other costs, fees and expenses
Loan agreements will almost always contain details of upfront fees and costs that the lender will insist on the borrower paying (e.g. arrangement fees). Other fees are things that may or may not become payable, such as prepayment fees or exit fees. Care should be taken to ensure that the borrower understands all circumstances that might trigger such fees, and where appropriate carve-outs to those triggers should be negotiated.
There are then further costs, which are less obvious. If the lender needs to involve solicitors during the life of the loan (e.g. to document any changes to the loan terms, or to advise on whether a potential breach has occurred), then the lender will want to pass those costs on to the borrower. Similarly, if advice from accountants or surveyors is required, again the lender will want the borrower to stand those costs. The lender will normally include an indemnity within its loan document under which the borrower agrees to indemnify the lender for such costs.
Can I object to these costs?
Lenders will usually resist amendments to cost indemnity clauses. However, if a cost is attributable to the negligence or mistake of the lender, then it is perhaps reasonable for such costs to be excluded from the scope of such indemnities. Sometimes borrowers will ask for lender’s costs to be restricted to those reasonably and properly incurred, but lenders will normally resist that amendment in so far as it extends to costs incurred enforcing its loan or security or protecting its security as a consequence of action taken by the borrower. In those situations the lender would argue that it is only right that it can fully recoup expense it felt it had to incur to protect its return.
Summary
In the Hollyoake case referred to earlier, Mr Hollyoake had sought to challenge the ability of his lender to charge extension fees (charged if he exercised options in his loan agreement to request extensions to the initial loan term), an early repayment fee (the loan agreement gave him the option to repay the loan early provided that all interest which would have accrued over the term of the loan was also repaid, which Mr Hollyoake challenged on the grounds of it being a penalty clause), and ‘double-interest’ (the loan agreement provided for payment of further (default) interest on sums which already included previously accrued interest). The court found against Mr Hollyoake on all three accounts, upholding the lender’s small print.
Borrowers should therefore ensure they fully understand how and when any costs, fees and expenses are to be incurred, and consider negotiating such provisions where possible before accepting an offer of funding.