ombudsman news gives general information on the position at the date of publication. It is not a definitive statement of the law, our approach or our procedure.
The illustrative case studies are based broadly on real-life cases, but are not precedents. Individual cases are decided on their own facts.
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.
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.
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.
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.
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.
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.
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:
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.