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The Prepayment Penalty Paradox

The Prepayment Penalty Paradox

Mark Scott

Thanks to the current low interest rate environment, an increasing number of borrowers in New Jersey are now electing to accept prepayment penalties in an effort to lock in historically low interest rates for the long term. Oftentimes what appears to be overwhelming cost or expensive course of action on the surface is simply much less expensive and an effective interest rate hedging strategy.

While most borrowers attempt to avoid prepayment penalties, there is a growing uncertainty about what the future might hold - whether it’s higher interest rates or simply political unrest, a result of failed fiscal policies on the part of the current Administration. As a result, more and more borrowers are biting the bullet when it comes to the prepayment penalties and locking in today’s low rates for 10 or 15 years or more.

In its simplest terms, a mortgage prepayment penalty is an obligation written into the loan documents that states that a penalty will be assessed if the entire loan, or sometimes part of the loan, is paid off before a certain date. This prepayment penalty is often used to protect lenders from the risk of an early repayment of principal (generally in a declining rate environment), and in most cases the borrower is rewarded for the prepayment penalty with a lower interest rate.

Prepayment penalties come in a variety of forms, including a fixed prepayment option, which establishes the exact amount of the prepayment for any period during the term of the loan and is usually offered by commercial banks and several portfolio lenders.

The cost of this fixed prepayment can be calculated when the loan is originated and is expressed as a percentage of the outstanding loan balance at the time of prepayment. Assuming a 10-year fixed-rate term loan, this figure will begin at a 5% in the first and second years and 4% in the third and fourth years, declining in similar fashion until the ninth and tenth years when the penalty would usually be 1%. Using the loan amortization schedule, the outstanding balance at any given point can be calculated along with the respective prepayment penalty. In this way, the borrower knows his “poison” - the penalty going into the loan.

A second option is a yield maintenance prepayment, which is predominantly used by insurance company lenders. Yield maintenance applies the theory of maintaining the loan yield upon prepayment by identifying the amount of supplementary cash that must be added to the loan payoff and to make the lender “whole” (a “make whole” provision). For example, if a lender was originally lent monies at 5% for 10 years, during which time rates dropped, and was then approached to pay off in a lower rate environment, they would suffer a reinvestment loss because they would be forced to accept lower reinvestment rates.

The final option is defeasance, which is defined as the substitution of other collateral for the real property collateral securing the loan and providing the same yield. Typically, the borrower uses proceeds from a refinance to purchase a portfolio of U.S. government securities that is sufficient to make all of the remaining debt service payments required by the note. The securities are pledged to the lender, and the lender releases the real estate from the lien of the mortgage. What’s most important to note about this selection is you will actually get money back if interest rates rise, whereas falling rates will result in a higher prepayment penalty.

As we move into 2013 and beyond, it is beneficial for all borrowers to review at their loan portfolios to see if they have any fixed prepayment penalties expiring. Given lenders current eagerness to put out new money, particularly as the New Year beings, not only are lenders willing to possibly discount yield maintenance penalties but also to blend and extend existing loans for longer terms.

In today’s contentious political and economic environment, it is time for borrowers to take a hard look at what makes the most sense for their bottom line. In fact, almost all of Commercial Mortgage Capital’s customers have had an extensive portfolio review and taken advantage of today’s current low rates to recast, unwind, extend or rebind their loans into new 10- to 15-year term loans. Additionally, any borrower that has a self-liquidating loan with anywhere from zero to seven years left should take an even closer look at those loans because the prepayment penalty is considerably less than one would expect.

Mark Scott is Principal of Commercial Mortgage Capital, based in Livingston, NJ. He can be reached at [email protected] or 973-716-0006.

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