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Loan Pre-Payment and Swap Breakage

A SWAP BREAKAGE CASE STUDY
Swap breakage fees arise if a swap is terminated prior to  maturity.  Most often a breakage fee will arise if a loan is refinanced early, or a property is sold prior to the maturity of the financing.  In extreme cases, breakage fees arise when a loan is in default and the swap is terminated by the bank.
Understanding swap breakage fees, and the potential downside is essential for sound risk management and borrowers should always understand potential breakage fees before committing to a swap.
Often times a swap dealer will tell a client that when a swap is terminated early the bank will pay the borrower if rates are up, and the borrower will pay the bank only if rates are down.  If only it were that simple.
Consider a 5 year swap on a $5 million loan priced at 1 month LIBOR plus 2.50%.

The bank's 5 year Swap Rate for the loan is: 4.67%
What will be the break fee in 1 year assuming rates are unchanged, rates are 50bps lower or if rates are 50bps higher?  You might think that if rates are unchanged there would be no break fee.  If rates are lower you will make a payment of approximately 50bps on the loan amount, and if rates are 50bps higher you will receive a payment of approximately 50bps on the loan amount. 
But the Rate Facts are wildly different:
Change in Rates Break (Fee)/Payment
No Change ($133,868)
Down 50bps ($234,259)
Up 50bps ($35,948)
 
In all three scenarios the borrower pays – and all three assume the dealer does not charge an extra hidden fee at unwind! (the bank almost always tries to charge an extra unwind fee).
What the borrower failed to understand is that when the swap rate was locked in, it contained a 40bp hidden swap fee, a fee that would add $98,446 to the cost of the financing and a fee that would negatively impact any break payment.  40bp is a standard swap fee for many regional banks. 
The 50bp rise in rates did impact break fees, but as the swap runs off the break fee will be calculated versus the market rate for the remaining maturity of the swap.  So when we cancel a 5 year swap after 1 year, we are comparing the original 5 year swap rate with a 4 year swap rate.

We will model potential swap breakage fees on your loan and swap before you lock in the rate.