Last Updated: 6-5-19
The prepayment penalty is a clause specified in a mortgage contract stating that a financial penalty will be assessed against a borrower if they significantly pay down or pay off the mortgage before a specified period of time.
“What you’re saying is that the lender will actually charge me a fee to give them their money back?”
As counterintuitive as that sounds, that is correct.
When a lender is underwriting a loan, they consider the fact that they will make money off of the interest payments. If you pay off a large portion of or the entire loan balance, the lender will no longer receive those interest payments. Therefore, the prepayment penalty protects the lender against the financial loss of interest income that would have otherwise been paid over time.
Typically, the prepayment penalty is incurred if the borrower significantly pays down or entirely pays off the loan balance via a refinance or sale within 1 to 3 years, and sometimes up to 5 years.
There are three main categories of prepayment penalties: (1) hard/soft prepayment penalties, (2) yield maintenance, and (3) defeasance.
(1) Hard and Soft Prepayment Penalties
The first category of prepayment penalties is referred to as hard and soft prepayments. A soft prepayment penalty allows a borrower to sell their home at any time without paying a fee. But, a fee is incurred if the borrower decides to refinance. A hard prepayment penalty does not allow the borrower to sell or refinance without paying a fee.
Both hard and soft prepayment penalties are either a percentage of the remaining loan balance (generally between 1% and 3%), a fixed amount, or a certain number of months’ worth of interest. For the latter, an example would be 80% of six months’ worth of interest.
(2) Yield Maintenance
The second category of prepayment penalties is yield maintenance. Yield maintenance is a prepayment penalty that allows the lender to attain the same yield as if the borrower made all scheduled interest payments up until the maturity date of the loan.
Remember, when a lender provides a loan, they do so with the expectation of receiving interest on the loan amount. If the borrow repays the loan amount earlier than expected, a yield maintenance premium can be charged, which allows the lender to earn their original yield.
The purpose of the yield maintenance prepayment penalty is to protect the lender against falling interest rates.
The yield maintenance premium is the difference between the amount of money the lender would have made from interest payments on the loan and how much money they would make if they were to “reinvest” the remaining loan balance. The most common investment vehicle used to calculate the yield maintenance is a US Treasury bond. For example, if the borrower repays the entire loan balance 5 years early, the yield maintenance would be the difference between 5 years’ worth of interest payments and the interest earned from a 5-year US Treasury bond.
Click for the US Treasury Yield Curve rates (1, 2, 3, and 6 month and 1, 2, 3, 5, 7, 10, 20, and 30 year) set by the Federal Reserve Bank of New York at or near 3:30pm each trading day.
The third category of prepayment penalties is called defeasance. Rather than getting charged a prepayment fee, the defeasance option allows the borrower to exchange another cash-flowing asset for the original collateral on the loan. Defeasance only applies to commercial real estate loans, while the other two prepayment categories apply to all mortgage loans.
The new collateral, which is normally a Treasury security, is usually much less risky than the original commercial real estate investment, so the lender is far better off because they receive the same cash flow they would have received from the interest payments on the loan and in return receive a much better risk-adjusted investment.
Which Prepayment Clause Should You Choose?
Each prepayment category has its pros and cons to both to borrower and the lender. The best option depends on your business plan and the investors’ expectations on future interest rates.
The benefit of having a prepayment penalty clause for the borrower is that they will receive a lower interest rate and lower closing costs compared to the same loan without a prepayment penalty. As long as your projected business plan is longer than the prepayment period, you benefit from the lower upfront and ongoing costs without having to worry about paying a prepayment fee. It gets a little trickier if you’re projected business plan is shorter than the prepayment period.
The hard and soft prepayment penalties is based on the timing of the refinance or sale, which make it easier to calculate upfront. If you secure a 5 years loan with a prepayment penalty during years 1 to 3, you should be able to calculate the prepayment penalty if you plan is to sell during year 2 – the fee is, for example, 1% of the remaining loan balance or 80% of six months of interest).
The other two prepayment categories are dependent on the interest rates at the time of sale or refinance, which requires some speculation on the part of the investor.
Generally, the yield maintenance premium and defeasance fees are based on the US Treasury rate, and the US Treasury rate is based on the market interest rate. As interest rates go up, the costs to invest in US Treasury rates go down, and vice versa.
If the borrower has a yield maintenance prepayment clause and the current interest rate is higher than the loan interest rate, the yield maintenance premium usually decreases to zero. When interest rate rise, US Treasury bonds are cheaper, so the difference between the remaining interest rates and the cash flow from buying US Treasury bonds or providing another mortgage loan is zero or a net gain to the lender. However, lenders will typically add a clause that if the yield maintenance is zero, a 1% to 3% prepayment fee is required. For example, the prepayment penalty may be the greater of the yield maintenance or 1% of the remaining loan balance. If an investor fees that interest rates will rise, selecting yield maintenance can be the cheaper option compared to a hard or soft prepayment penalty fees or defeasance payments.
The defeasance fee is also based on the US Treasury rate. However, unlike yield maintenance, the borrow can technically make money with defeasance. Again, if interest rates on loans rise to a rate greater than the loan’s interest rate, US Treasury bonds lose value and become cheaper. The borrower is then able to purchase the required bonds for less than what is required to repay the loan, yield maintenance vs prepayment penalty, resulting in additional cash flow. However, if interest rates fall, US Treasury bonds gain in value and the borrower has to pay an amount greater than the loan balance at prepayment. Defeasance is good if the investor thinks interest rates will rise or plans on selling their multifamily property early and are worried about the potential increase in mortgage payments with a floating rate loan. However, the defeasance process is quite complicated. The investor will likely need to hire a defeasance consultant, which increases the associated costs.
Overall, prepayment penalties protect lenders from falling interest rates and allow borrowers to negotiate loans with lower interest rates and lower closing costs.
With the hard and soft prepayment clause, an investor can accurately predict the prepayment fee as long as they have a good idea about when they will sell or refinance. However, these fees will likely be the highest of the three.
Yield maintenance is less predictable than the hard and soft prepayment costs. However, if interest rates rise, the fee will be less than the hard and soft prepayment fees and maybe even the defeasance fee. But the investor will always have to pay a fee of some amount.
Defeasance is also less predictable than the hard and soft prepayment costs. However, defeasance is the only category of prepayment penalties that can result in a net gain to the borrower, depending on how high interest rates rise. There are also added costs with defeasance, because it is necessary to hire a consultant to structure the defeasance portfolio and send ongoing payments to the lender.
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Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.