Prepayment Penalties
Prepayment penalties are fees that lenders typically collect from borrowers who pay loans off early.
What Are Prepayment Penalties for Self-Storage Loans?
A prepayment penalty is a type of fee that lenders may charge a borrower who pays off a loan before the maturity date. In most commercial finance transactions, a borrower is expected to pay interest on the principal loan amount — the interest paid acts as compensation to the lender for the use of its money over a period of time. The interest on a loan dictates the lender’s rate of return. Prepayment penalties were created in order to ensure that even if a borrower were to pay a note off at a significantly earlier date, the lender would still receive an adequate income from the loan.
In many lending cases, a prepayment penalty is just a simple fee. In commercial finance, however, with loan sums that can reach well into the millions, there are three widely adopted prepayment penalty options borrowers must be aware of: yield maintenance, step-down prepayment, and defeasance.
Understanding Different Types of Prepayment Penalties
Yield Maintenance
Yield maintenance is a much simpler prepayment penalty that enables lenders to receive the same yield from a prepayment of a loan that they would have received through scheduled monthly payments up to the loan's maturity date. In execution, a yield maintenance clause stipulates that a borrower must pay the difference between the interest rate on the loan and the standing market interest rate on the prepaid capital up to the loan’s maturity date. Loans with yield maintenance typically do not have a lockout period — which completely bans all prepayment within a set period of time, usually during the first three years of the loan term — but are often accompanied by an initial prepayment fee.
Step-Down Prepayment
Step-down, or graduated, prepayment is a straightforward declining payment schedule that is calculated based on the remaining balance at prepayment in conjunction with the amount of time that has passed since the closing of the loan — or the most recent rate reset. The step-down moniker comes from the gradual reduction of the penalty borrowers are expected to pay as the loan matures.
Step-down prepayment schedules are found in a plethora of configurations, but the 5-4-3-2-1 schedule is one of the most common. To illustrate how step-down prepayments work, consider the 5-4-3-2-1 step-down for a five-year loan term. This configuration means the borrower is responsible for paying a penalty of 5% of the outstanding balance if prepaying the loan in the first year, 4% if in the second year, 3% if in the third year, and so on.
Defeasance
The term defeasance is generally defined as a stipulation in a finance contract that voids a bond or loan on a balance sheet provided the borrower sets aside cash (or other financial instruments) whose value would be sufficient for servicing the debt. In simpler terms, defeasance is the replacement of a loan’s collateral with securities that will provide a lender, at the very least, an equivalent return to what they would have made if the loan reached its maturity date.
Fixed-rate government bonds — usually U.S. treasury bonds — are the most commonly used securities for defeasance. What matters most, however, is not the type of security used, but rather that the total value the securities are able to provide the lender is, at the very least, the same as what the loan itself would generate.
Related Questions
What is a prepayment penalty?
A prepayment penalty is a type of fee charged to a borrower who pays off a loan before the maturity date. With most commercial real estate loans, the borrower is expected to pay interest on the principal loan amount. The interest that the borrower pays represents compensation to the lender for the use of its money over a period of time, essentially dictating the lender’s rate of return. The way most commercial loans are structured, when a borrower is able to pay the loan in full ahead of schedule — without prepayment penalties in place — the lender stands to lose out on the interest that would have been earned monthly over the life of the loan.
In commercial real estate loans, a prepayment penalty is a fee charged to borrowers if they attempt to repay their loan early. When a lender issues a loan, they typically want to lock in their profit for a certain amount of time. Basically, the prepayment penalty is a way to compensate them for their financial loss if the loan is paid off early.
What are the different types of prepayment penalties?
The three main types of prepayment penalties are defeasance, yield maintenance, and step-down prepayment. Defeasance involves replacing the loan with a portfolio of government securities, yield maintenance requires the borrower to pay a fee to make up for the lost interest, and step-down prepayment involves a declining payment schedule based on the remaining balance and the amount of time since the loan was closed or the most recent rate reset.
Learn more about Defeasance Prepayment Penalty, Yield Maintenance Prepayment Penalty, and Step-Down Prepayment Penalty.
What are the advantages and disadvantages of prepayment penalties?
Prepayment penalties are designed to protect lenders from the loss of income they would experience if a borrower pays off their loan early. The advantages of prepayment penalties are that they provide lenders with a more fair return should the debt be paid off before fully maturing. The disadvantages of prepayment penalties are that they can be costly for borrowers, depending on the terms of the loan, and can sometimes be a significant amount of money.
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How do prepayment penalties affect a borrower's loan?
Prepayment penalties are fees charged to a borrower who pays off a loan before the maturity date. These penalties are designed to ensure that the lender still receives an adequate income from the loan, even if the borrower pays it off early. In commercial real estate finance, lenders typically implement one of three prepayment penalty options: defeasance, yield maintenance, or step-down prepayment.
Defeasance is a process in which the borrower replaces the existing loan with a portfolio of U.S. Treasury securities. Yield maintenance is a penalty that is calculated to compensate the lender for the difference between the original yield of the loan and the yield of the loan if prepaid. Step-down prepayment is a penalty that decreases over time, allowing the borrower to pay off the loan without a large penalty.
The cost of the prepayment penalty will depend on the terms of the loan, and can sometimes be a significant amount of money. Prepayment penalties can affect a borrower's loan by increasing the cost of the loan if they choose to pay it off early.
What are the legal implications of prepayment penalties?
Prepayment penalties are legal in most states, but the exact terms and conditions of the penalty must be clearly outlined in the loan agreement. The penalty must also be reasonable and not be used to punish the borrower for prepaying the loan. In some states, prepayment penalties are limited to a certain percentage of the loan amount or a certain number of months of interest. Additionally, some states have laws that limit the amount of time a prepayment penalty can be in effect. For example, in California, prepayment penalties are limited to three years.
It is important to note that prepayment penalties are not allowed in all states. For example, in North Carolina, prepayment penalties are not allowed on loans with a term of less than five years. Additionally, some states have laws that limit the amount of time a prepayment penalty can be in effect.
It is important to consult with a qualified attorney to ensure that the terms of the loan agreement are in compliance with the laws of the state in which the loan is being taken out.
How can a borrower avoid prepayment penalties?
A borrower can avoid prepayment penalties by negotiating with the lender to remove them from the loan agreement. This is not always possible, however, as lenders may require prepayment penalties to ensure they receive an adequate return on their investment. If the lender does not agree to remove the prepayment penalty, the borrower can still reduce the amount of the penalty by negotiating the terms of the penalty. For example, the borrower can negotiate a lower fee or a graduated or “step-down” prepayment penalty, which reduces the penalty amount over time.
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