Nothing says romance quite like a prenuptial agreement does it?

That comment is certainly facetious, but sets the stage for an analogy regarding the prepayment penalty aspect of commercial loans. It is important to understand what you’re getting into with your loan. The loan documents explain all the terms of the loan, and the prepay piece is really the predetermined cost of breaking up with a lender.

A prenuptial agreement defines and outlines what things will look like in the event of a separation. No couple enters a marriage with the intent of divorce, but it happens.

Likewise, most investors enter a loan agreement with the intent of carrying the loan in accordance with the defined term. In the event it makes more sense to do something different, the loan documents spell out what the financial ramifications are for that breakup.

That makes it very important to understand what different prepayment penalty structures are so you can make the best decision when entering into that commitment with the lender.

My goal is stay as neutral as possible in describing the options along with some of the associated pros and cons. There are trade-offs in this game and like the old saying goes… it is hard to have your cake and eat it too.

With prepayment penalty structures, there are a couple general rules of thumb

1. The longer the fixed interest rate, the longer the prepayment penalty.
2. Loans that have the lowest interest rates generally have the strongest prepayment penalties.

It is all about risk and return for a lender. If a lender knows they will receive a certain income stream, i.e. it is guaranteed, for a fixed period they are able to price that loan at a lower rate because there is less risk.

If there is a high probability of prepayment, there is more risk involved with that loan so the pricing (interest rate) goes up.

Three Most Common Types of Prepayment Penalties Defined:

Step-Down – Common with Bank and HUD loans

This type of prepayment penalty is a gradually declining penalty over the term of the loan. It is the most common type of prepayment penalty with bank loans. One advantage is that it is easy to calculate. A typical 5-year term might have the following prepayment penalty: 5-4-3-2-1.

The numbers represent a percentage of the outstanding loan balance the prepayment penalty will be. Here’s an example of $1,000,000 outstanding loan balance.

In this example, in the first years of the loan, the borrower’s penalty will be five percent of the existing loan balance. Year 4 would be a 2% prepayment penalty.

And in the last year, the prepayment penalty goes away entirely the last 3-6 months of the term.

Pros: Low cost to exit the loan early

Cons: Usually recourse loans; higher interest rate; not assumable

Yield Maintenance – Common structure for Fannie Mae, Freddie Mac, and Life Co Loans

This type of prepayment penalty protects the lender against a decline in interest rates. In an environment where interest rates are declining, borrowers typically try to refinance their loans to reduce the interest rate on their debt.

If the loan is paid off early and interest rates are lower than when the original loan was closed, the lender loses a high-yielding investment. This means they would have to redeploy those funds at a lower rate and get a lower rate of return on them. To reduce the effect of an early payoff, lenders often require that the borrower provide compensation, called yield maintenance.

A technical explanation of yield maintenance is the prepayment penalty calculates the net present value of the remaining interest due on the loan to the end of the prepayment period. The loan payoff discount rate would be the difference between the new interest rate and the original mortgage’s interest rate. The difference between the two cash flows for the remaining of the balance of the original loan term, discounted to the present, is the yield maintenance prepayment penalty.

The short and sweet explanation is whatever amount of interest you sign up for in the term of the loan, you will pay it. If there are 3 years left on the loan, you will pay that amount of interest. That is over-simplified because you do have to factor in any variance between current interest rates and the note rate, but easier to wrap your head around.

Pros: non-recourse loans, lowest interest rates; assumable

Cons: Higher cost to exit the loan early

Defeasance – CMBS Loans

Defeasance is the substitution of the current collateral (the property) with US Treasuries that exactly mimic the stream of payments promised at the origination of the loan. The borrower’s property is released in exchange for this new collateral.

If Treasury rates rise above the original mortgage rate, the borrower benefits from this, because the price of Treasuries will fall, and the borrower will be able to setup a portfolio that mimics the original cash flows at a lower price than the amount that would have had to be repaid.

With yield maintenance, the note is paid off. But with defeasance, the note continues to term. Defeasance does not change anything about the cash inflows to the lender. While yield maintenance penalizes the lender when Treasury rates fall, fluctuations in the Treasury rates do not affect the lender using defeasance.

Pros: non-recourse loans, low interest rates, high leverage; assumable

Cons: Complicated process to setup; high cost to exit the loan early

Other Considerations

There are some lenders that have lockout periods at the beginning of the loan that will not allow you to pay off the loan. Generally, a lockout period is the first one or two years of the loan. After the lockout period expires, the borrower can prepay the loan. Lenders with a lockout period generally have yield maintenance for a prepayment penalty.

Some lenders will allow you to pay down up to 20 percent of the loan balance in any given year without incurring a prepayment penalty. If your goal is to pay off the loan as soon as possible, this is a perfect prepayment option to have.

Before Choosing the Type of Prepayment Penalty Know Your Exit Strategy

Now that you know the basics about prepayment penalties, you’re ready to decide what structure makes most sense for you.

It is so stinking easy to focus on the interest rate as the most important element of the loan. It may or may not be. That isn’t the purpose of this discussion. The purpose is to educate and help you ask better questions so you can make better decisions.

None of us know what the future holds, we hope our marriages last forever and our loans go full term. But life is full of curve balls.

The best advice I can give to an investor around prepayment penalties is to really know your exit strategy. There should be multiple exit strategies both considered and in place. Whatever aligns best with the most probable exit strategy based on your due diligence and business model is the way to go.