Dr Skinner argues that such redemption charges may be justified but only if they recover the lender s cost in providing the option plus a reasonable handling charge. The value of the option decreases according to the level of interest rates at the time the loan is redeemed and decreases over the period of the loan, becoming worthless at the end of the fixed rate period. Dr Skinner s research shows how, despite interest rate volatility, lenders can reliably estimate a cash value for early redemption charges when the mortgage offer is made. In order to value the consumer s option Dr Skinner uses the Black Derman and Toy model of stochastic interest rates which generates a binomial tree of future interest rates. This is adjusted so that it matches the term structure of UK gilts and therefore reflects market expectations.
Many lenders levy redemption charges for all types of mortgage, whether fixed or variable rate.
This is generally expressed in terms of a number of months interest, or a number of monthly installments, payable over and above the capital balance at redemption. For fixed rate or discounted loans, the redemption charge typically applies for the period of the fixed rate or discount, but in some cases extends beyond this. In some cases the redemption charge reduces over time, but in others it remains constant regardless of when redemption takes place. Administration charges are typically added on. A redemption charge may be regarded as a penalty even if it is expressd as the price for exercising a right rather than a consequence of breaking the agreement.