Break fees on fixed rate loans drive up disputes

The banking and finance division of the Financial Ombudsman Service has reported that the number of disputes it is handling doubled in the second half of 2008.

Banking and finance ombudsman, Philip Field, said in a newsletter issued this month that a large number of complaints were about break fees on fixed rate loan contracts.

The banking and finance division of FOS received 5085 new disputes in the six months to December. This was more than double the number received in the six months to December 2007.

Field said: "The increase is perhaps a reflection of the present economic environment."

Because of the big increase in disputes relating to break fees on fixed rate mortgages the ombudsman has set up a project team to deal with these matters.

The ombudsman has also issued a guide to its approach to disputes involving break fees on fixed rate loans.

The ombudsman will consider whether the fee has been properly disclosed to the customer, whether the fee has been charged in accordance with the borrower's contract and whether the size of the fee conforms to any scale of charges applied by the lender.

If the loan is regulated by the Consumer Credit Code the ombudsman will look at whether the fee exceeds "a reasonable estimate of the credit provider's loss arising from the early termination."

The most common complaint is that the lender did not inform the borrower that an early repayment fee would be charged if they paid out their loan before the expiry of the fixed rate period, or if some explanation was given, it did not adequately describe the manner in which the early repayment fee would be calculated.

The ombudsman has set out a formula for estimating the cost to the lender of an early repayment, which it may apply if there is a dispute about the amount.

The approximate amount of a loss suffered by a lender can be estimated by multiplying the amount of the loan by the remaining term of the fixed interest period and the movement in the lender's cost of funds.

For example, the economic cost to the lender of  a borrower repaying a loan of $100,000 that had two and a half years to run, with a movement of one per cent in the cost of funds, would be $2500 ($100,000 x 2.5 x 1%). This amount would be discounted to reflect the present value of receiving projected future cash flows in advance.

The guide says: "The ombudsman accepts that how a financial services provider determines its cost of funds is commercially sensitive and it is under no obligation to disclose that information to its customers."

If lenders supply their internal cost of funds the ombudsman will use those in its calculation. Otherwise it will use a formula involving the bank bill rate and the appropriate swap rate.