| Single-figure
base rates have become the norm in recent years, but many people
can remember when (not that long ago) interest rates were three
times what they are now. So fixed rates provide an obvious benefit
to borrowers – who know their repayments will remain affordable
throughout the fixed rate period.
Fixed
rate loans for businesses have generally been around for rather
longer than they have for domestic mortgages. And the trend towards
lenders making early repayment charges linked to interest rate
movements arrived in the business loan market before moving to
the domestic mortgage. An increasing number of businesses are
complaining to us about this type of early repayment charge.
why
make a charge?
We have no quarrel with the principle of lenders imposing reasonable
early repayment charges on fixed rate loans that are repaid early.
Typically – to balance their books – lenders fund fixed rate loans
by borrowing in the money market at fixed rates for fixed terms.
If borrowers redeem their loans early, lenders can be left to
pay interest on their own borrowing. And if interest rates have
fallen in the meantime, the lenders will face a shortfall between
what they can earn on the repaid money and what they still have
to pay on their original money market loans. But why draw a distinction
between the market for business loans and the market for domestic
mortgages? Are there different considerations between those two
markets? Well, the simple answer is – yes, there are. That’s the
reason for this article.
legal
position
transparency
The law says that adults (including those who sign on behalf of
a business) are usually bound by any contracts they sign – whether
or not they read them or understand them.
But
unusual or onerous contract provisions are not binding if they
are buried in the small print. And, because of their potential
impact, early repayment charge provisions will usually be onerous.
They must therefore be fairly brought to the attention of the
person signing the contract – either by being obvious and intelligible
in the contract itself, or by being pointed out and explained.
To
this extent, the position is broadly the same whoever the lender
is dealing with. But how far should the average business be treated
differently from the average domestic mortgage borrower?
We
take the view that someone who runs a business should be more
used to dealing with business contracts. So we generally expect
a higher level of understanding from business owners, or a higher
readiness to seek professional advice on anything they don’t understand.
Put another way, business owners will find it more difficult to
satisfy us that they should not be bound by the clear terms of
a document which they have signed.
But
there are different sorts of business borrower. At either extreme,
a lender could be dealing with highly qualified and experienced
people running a substantial business, or with an inexperienced
sole-trader who’s only just gone into business, perhaps using
the trade he learned as an employee before being made redundant.
We
are required to decide cases on the basis of what is fair in the
circumstances. The contract documentation needs to be appropriately
intelligible. But experienced business people who did understand
cannot escape liability because a less experienced person might
not have done.
Some
lenders’ business loan agreements and domestic mortgage agreements
contain similar contract provisions, but are very differently
worded. The business loan agreement is usually the one the lender
has not reviewed as recently, so its language is generally much
less plain. There seems no good reason for that.
fairness
Our adjudicators have already decided a number of domestic mortgage
cases in favour of borrowers because the early repayment charge
provision, though brought sufficiently to the borrower’s attention,
was unfair under the Unfair Terms in Consumer Contracts Regulations
(see page 26 of the March 2001 edition of ombudsman news for just
one example).
But
– at least for the purposes of those Regulations – businesses
are not consumers. So, the Regulations do not apply to business
loans. That can produce unfortunate results for inexperienced
sole-traders. In effect, they alternate several times each day
between being a consumer and being a business owner – but they
are treated differently by the law, depending which ‘legal hat’
they are wearing.
practical
issues
how
is the early repayment charge calculated?
Early repayment charges based on the movement in market interest
rates usually start from the fixed rate at which the lender actually
lent to the borrower. The movement is measured to some current
rate – typically either the current fixed rate at which the lender
says it will lend money to new borrowers or the current fixed
rate it says it can get by reinvesting the money on the money
market.
To
calculate the charge, the interest rate differential is then multiplied
by the amount being repaid early and the unexpired term of the
original fixed rate period. Some lenders then go on to discount
that figure to give a ‘net present value’. This takes into account
the fact that the lender is getting its money in one go, earlier
than it would have done if the loan had continued for the full
fixed rate period.
But
the way in which some lenders calculate their charges does not
always agree with the ‘explanations’ that appear in their own
loan agreements. Some of those ‘explanations’ appear unnecessarily
complex or ambiguous. And there are some common principles that
lenders could adopt to achieve reasonableness and fairness.
The
key points are perhaps best illustrated by some recent examples.
| case
study – early repayment charges on business loans
06/02
Here
is an extract from one lender’s early repayment charge provision:
‘…
any loss will reflect the cost to the Bank of unwinding
funding transactions undertaken in connection with the
Loan. Costs will be incurred when there has been a reduction
in the Market level of the appropriate interest rate underlying
the Loan. The cost will be equivalent to the loss of interest
income (including loss of margin) to the Bank as a result
of re-deploying funds at a lower interest rate than that
which prevailed when the Loan was booked.’
Our
adjudicator was satisfied that the contract provision had,
in this case, been satisfactorily drawn to the attention
of the borrowers, M & C. However, M & C did not think the
lender was actually calculating the charge in accordance
with its own explanation. The reference to ‘a reduction
in the Market level of the appropriate interest rate underlying
the Loan’ should be taken as referring to a current lending
rate.
The
lender was using the rate at which it said it could reinvest
the money on the money market for the remainder of the original
fixed rate period; this produced a higher early repayment
charge. Although the lender may have intended to operate
the clause in this way, it did not actually say that ‘redeploying’
meant reinvesting. The lender prepared the documents – and
it is a well-established principle that any uncertainty
in a document is to be construed against its author.
During
our adjudicator’s investigation, we also suggested to the
lender that to reflect the true loss to the lender, the
charge should be discounted to its net present value – even
though this was not specifically stated in the contract
provision. The lender responded initially by saying it only
did this when the early repayment charge exceeded £100,000
(in this case, it was a little over £90,000).
On
appeal, the ombudsman upheld the adjudicator’s decision.
But before we issued a final decision, the lender told us
it had changed its policy and now discounted all early repayment
charges – at a higher rate than the adjudicator suggested
in his adjudication.
So,
in the event, the overall reduction in the early repayment
charge increased between our adjudication and final decision.
M & C have not yet repaid the loan but, when they do, the
effect of our recommendation will be to reduce the early
repayment charge by more than a third. |
|
06/03
In
this case, involving a different lender, the borrowers,
S&J, were given a choice when they took out their £380,000
loan.
They
could pay either:
- a
non-refundable prepayment option fee of 1.5% of the loan
‘up-front’; or
- a
market-rate early repayment charge if they wanted to repay
some or all of the loan before the end of the twenty-year
fixed rate period.
S&J
decided not to pay the 1.5% fee (£5,700) and took the risk
of an early repayment charge.
The
early repayment charge provision in the loan agreement said,
among other things, that the borrowers indemnified the lender
against any funding losses it incurred as a result of early
repayment. The clause went on to say that the amount the
lender claimed could not be challenged – unless the figure
was obviously, and blatantly, wrong.
When
S&J wanted to repay their loan early, they were not happy
with the size of the early repayment charge – it was over
£30,000. And although our adjudicator decided that S&J were
required to pay a charge, she considered that the lender
was not calculating the charge fairly, in accordance with
the contractual provision. She also decided that the lender’s
statement that the amount due was not open to challenge
did not prevent her from delving into the formula it had
used.
When
she did so, she discovered that when the lender identified
the current lending rate for the purpose of calculating
the charge, it did not necessarily do so on the same day
the borrowing was to be repaid. So there could be a mismatch
either way – benefiting either the borrower or the lender.
We considered the lender should not approximate the figure
in this way, when the contractual provision did not provide
for it. Borrowers are entitled to have their charges calculated
accurately.
In
this case also, the lender did not discount the early repayment
charge to its net present value. But we said that it should
do that too. So the overall effect of our recommendations
was to say that the lender should make a substantial refund
to the borrowers.
Although
the lender is now challenging the exact calculation of the
discount, it does accept that the way it applied its early
repayment charge formula meant that it had charged the borrowers
too much – and that discounting was appropriate.
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