What is a breakfunding fee in a commercial mortgage?

What is a Breakfunding Fee?

A breakfunding fee in a commercial mortgage is a prepayment penalty applied to variable or floating-rate loans, calculated based on the difference between the loan's interest rate at prepayment and the current market rate. This fee compensates lenders for lost income due to early loan repayment, particularly when market interest rates have fallen. For borrowers, it represents a potential significant cost in scenarios of early refinancing or loan payoff, especially in a declining rate environment.

How Does a Breakfunding Fee Work?

A Breakfunding Fee in a commercial mortgage is a type of prepayment penalty, typically associated with variable or floating-rate loans. This fee compensates the lender for the loss incurred due to the early repayment of the loan. Here's how it generally works:

  1. Context of Variable Rates: In variable-rate loans, the interest rate fluctuates based on a benchmark rate, like LIBOR or SOFR. If a borrower prepays their loan, the lender loses the anticipated income from future interest payments, which may have been calculated based on expectations of rising rates.
  2. Calculation of the Fee: The breakfunding fee is calculated based on the difference between the interest rate the borrower was paying at the time of prepayment and the current market rate for loans of similar duration and risk. If interest rates have fallen since the loan was originated, this can mean a higher fee.
  3. Purpose: This fee is designed to recover the lender’s lost income or "funding breakage" - the cost the lender incurs in lending out the funds at a lower interest rate than they were originally receiving.
  4. Impact on Borrowers: For borrowers, a breakfunding fee can be a significant expense, especially in a declining interest rate environment, and should be considered when evaluating the total cost of refinancing or paying off a loan early.

Breakfunding fees are designed to compensate lenders for the loss of expected interest income when a variable-rate loan is prepaid, especially in situations where market interest rates have declined since the loan's origination.

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