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Prepayment Penalties

Avoid Commercial Real Estate Loan prepayment penalties

Commercial Loan Prepayment Penalties

Borrowers are looking for the security of long term fixed rate commercial loans but then balking at the prepayment penalties that come with them. But do you really understand how these prepayment penalties work?

Why prepayment penalties?

First, prepayment penalties are based on the need for lenders to receive a level rate of return over the term of their investment. Thus if a loan pays off in a decreasing interest rate environment, the lender will receive a lower return than planned. As any investor knows, this is not good.

Since it is unrealistic to assume that no loans will prepay, the prepayment penalty is designed to give the lender a level rate of return. If rates go up, the lender is happy to get the prepayment since the lender can now reinvest at a higher rate. But if rates are lower, the penalty kicks in.

Calculating the prepayment penalty

Most lenders use Treasury notes as the index for their interest rate computation. A five year term loan will be matched with a five year treasury. Typically a commercial loan will be indexed at 300-400 basis points over the like term Treasury note.

And when it comes to the prepayment penalty, the same index is used. For example, when a ten year fixed rate loan pays off after five years, the prepayment penalty will be based on the remaining five years.

The lender will calculate the remaining balance of the loan and the income that will be lost on that loan. By comparing the difference between the yield on the loan and the yield on a five year treasury note, the lender determines the penalty.

The actual penalty is calculated as the present value of the difference between the two streams of payments. Thus, if the lender is going to get $30,000 less over five years, the present value is $23,800 and that is the amount the borrower will be expected to pay as the prepayment penalty.

Avoiding prepayment penalties

• You can avoid prepayment penalties by accepting a one year adjustable rate loan. These loans typically do not contain prepayment penalties.

• Plan the term of the loan to coincide with divestiture plans. Thus, if you selling the property within five years you should have the loan mature in five years.

• Request an assumption clause in the note. Most lenders will accommodate this request with the caveat that the new borrowers will have to qualify for the loan. The assumption of the loan means there would be no prepayment penalty.

About the Author

Gary Crum is nationally published author with over twenty five years of management experience in the banking industry. He has a BSBA in Human Resources Management from Florida State University and an MBA from Florida Atlantic University.