Early Exit Costs is an umbrella term covering:

1) the Early Repayment Charges  applicable to fixed rate residential mortgages; and

2) the Market Break Costs applicable to fixed rate business loans and other varieties of tailored business loan.

Early Repayment Charges (ERCs)

ERCs apply to most fixed rate residential mortgages.  They are the penalty fees payable by borrowers making early repayment of all or part of their loans.  ERCs are disclosed in advance and are normally expressed as a percentage of the amount being repaid early.  

ERCs vary between different loans and lenders but typically follow the pattern set out in the table below.

Remaining length of fixed rate period	Early Repayment Charge
More than 5 years	5% to 6% of the amount repaid
4 to 5 years	5%
3 to 4 years	4%
2 to 3 years	3%
1 to 2 years	2%
Less than 1 year	1%

Disadvantages of Early Repayment Charges

1)      Unexpected events

Most borrowers taking out a fixed rate mortgage intend to keep their loan at least until the expiry of the fixed rate period.   They rarely plan from the outset to exit their loan early; so they tend to discount the likelihood of incurring early exit penalties. 

But sometimes borrowers’ plans are forced to change.  This may be because of an unforeseen ‘life event’ such as divorce, illness, loss of employment or moving to a new home.  In these cases, early repayment penalties can suddenly become an expensive reality.  

2)      ERCs can be substantial

A benefit of the ERCs applicable to residential fixed rate mortgages is that they are transparent and clearly disclosed in advance.  But ERCs can be substantial, especially when compared to the loan interest rate.  The interest rate on some fixed rate loans taken out in 2020 and 2022 was below 2%.  For those loans, a 3% early repayment penalty equates to 18 months or more of interest payments.

3)      No break benefit for the borrower

In a rising interest rate environment, fixed rate mortgages being repaid early tend to have lower rates of interest than would apply currently.  Commercially, one might expect the lender to pay a fee to the borrower for the early repayment, because the lender can now re-lend the repaid money at the new higher interest rate.  But the inflexible nature of ERCs does not allow this.  The lender does not pay a fee to the borrower reflecting the commercial value of the early repayment.  Instead, the borrower must pay a penalty fee to the lender.

4)      Loss of flexibility

High ERCs reduce borrowers’ flexibility to switch lenders, for example to take advantage of alternative, more attractive, financing offers or to extend their protection by locking into longer-dated fixed rate loans.  The high cost of ERCs tends to make such switching uneconomic for the borrower.

Market Break Costs

The Market Break Cost is the amount payable by a business borrower wishing to exit an interest rate swap, fixed rate business loan or other form of tailored business loan. The Market Break Cost can be significant in relation to the size of the underlying transaction.

As the name suggests, the Market Break Cost reflects market conditions at the time of the early repayment.  If interest rates have fallen, the Market Break Cost can be a high percentage of the loan value.  In some recent cases, the Market Break Cost has been more than 60% of the amount borrowed, meaning that borrowers with loans of £10 million have had to repay more than £16 million to exit those loans.

The lender will normally advise the borrower to take independent legal advice before entering into any agreement having a Market Break Cost.  This is necessary because the break cost calculation can be complex and uses data which may be opaque to all but the most sophisticated borrowers.  In some cases, depending on the legal documentation of the arrangement, the borrower may have the possibility to receive a market break benefit, calculated in a similar way.

The contingent liability created by Market Break Costs is another factor which is rarely fully understood, even by relatively sophisticated business borrowers.  The contingent liability calculation includes the Market Break Costs potentially payable by the borrower in the event of loan default.  The contingent liability may have an adverse impact on key credit metrics, including the borrower’s loan-to-value ratio.  Lenders mark the contingent liability against the borrower’s credit file, meaning that borrowers may find themselves in financial difficulty even if they have never missed a loan payment.

Interest rate caps

Interest rate caps allow borrowers to insure against rising interest rates without the risk of early exit costs.  If the cap premium has been paid upfront, there can never be a cost to exit a cap early.  A stand-alone cap is separate from the borrowings it protects.  If the underlying loan is repaid early, the borrower may choose to redeem the cap, possibly earning a redemption fee (but never paying a break fee), or else to retain the cap, for example to protect other borrowings.