The Prepayment Fee – The Fine Line between Mortgage Maturities
Prepayment penalties can be a substantial latent cost for borrowers, as well as attractive profit protection for lenders. Borrowers require flexibility, while lenders seek yield preservation.
Prepayment language is more important today, as the yield curve favors long-term debt with better pricing and terms than shorter maturities. All things being equal other than term, the major difference between notes rests within the prepayment calculations.
Nearly all short-term loans of five years or less have liberal prepayment penalties, and in some cases, none. Long-term debt is often burdened by the prepayment penalties that can cost as much as 10% of the loan balance, depending on the formula used.
Some overall rules about prepayment penalties are as follows:
1) Usually locked out from prepayment during first half of the term
2) Negotiable if coupon rate is substantially below current market rate
3) Minimum penalty typically at one percent
4) Yield-maintenance formula works best for borrowers expecting lower rates later in the term
5) Declining Balance formula provides calculated certainty in loan payoffs
6) Defeasance formula requires costly processing and multiple approvals – more applicable for locked cash flow loans (e.g., long-term, net lease properties)
7) Types of funding sources have a direct correlation on prepayment formulas (e.g., balance sheet lender has more flexibility than lender intending to sell the note)