A discussion on getting the best possible loan for your property would not be complete without talking about prepayment penalties.  There are prepayment penalty traps that you, the borrower, need to be aware of so that you avoid choosing a loan that you will later regret.

On a regular basis I am contacted by property owners who want to refinance their properties.  When I ask them if their existing loan has a prepayment penalty many times they can’t recall.  I tell them the first thing they need to do is to review their loan documents to find out what their current prepayment penalty is.  When they call me back and tell me the type of prepay, many times I have to be the bearer of bad news.  As much as I would like to refinance their property, the size of prepayment penalty precludes that from happening.

But I’m jumping the gun.  Let’s begin with the basics about prepayment penalties and then you’ll understand why many times I have to give the borrower this bad news.

Two rules of thumb about prepayment penalties:

1. The longer the fixed interest rate, the longer the prepayment penalty.

This is just plain common sense.  If you request a five-year fixed rate, your prepayment penalty will be five years or less.  If you request a ten-year fixed rate, your prepayment penalty will be for ten years or less.  Surprising to me is how many borrowers regularly ask for the best of both worlds.  They want the longest fixed rate interest rate possible and they want the shortest prepayment penalty.   You can have one or the other.  You can’t have both.

2. Lenders that have the most competitive interest rates generally have the worst prepayment penalties.

Three most common types of prepayment penalties are:

1. Step-Down

This type of prepayment penalty is a gradually declining penalty over the term of the loan.  It is the most common type of prepayment penalty and it has the advantage of being very easy to calculate.  A typical ten-year term might have like the following prepayment penalty: 5-5-4-3-2-1-1-0-0-0.  In this example, in the first two years of the loan, the borrower’s penalty will be five percent of the existing loan balance.  And if the borrower can wait to pay the loan off during the seventh year or later, the borrower will avoid paying a prepayment penalty altogether.

2. Yield Maintenance

This type of prepayment penalty protects the lender against a decline in interest rates. In an environment where interest rates are declining, borrowers typically try to refinance their loans to reduce the interest rate on their debt.

If the loan is paid off early at a lower interest rate than when the original loan was closed, the lender loses a high-yielding investment and gets, in return, a lower rate of return on it. To reduce the effect of an early payoff, lenders often require that the borrower provide compensation, called yield maintenance.

The yield maintenance prepayment penalty calculates the net present value of the remaining interest due on the loan to the end of the prepayment period. The loan payoff discount rate would be the difference between the new interest rate and the original mortgage’s interest rate. The difference between the two cash flows for the remaining of the balance of the original loan term, discounted to the present, is the yield maintenance prepayment penalty.

3. Defeasance

Defeasance is the substitution of the current collateral (the property) with U.S. Treasuries that exactly mimic the stream of payments promised at the origination of the loan. The borrower’s property is released in exchange for this new collateral.

If Treasury rates rise above the original mortgage rate, the borrower benefits from this, because the price of Treasuries will fall and the borrower will be able to set up a portfolio that mimics the original cash flows at a lower price than the amount that would have had to be repaid.

With yield maintenance, the note is paid off. But with defeasance, the note continues to term. Defeasance does not change anything about the cash inflows to the lender. While yield maintenance penalizes the lender when Treasury rates fall, fluctuations in the Treasury rates do not affect the lender using defeasance.

Lock-Outs and Paydowns

Also, there are some lenders that have lock-out periods at the beginning of the loan that will not allow you to pay off the loan.  Generally, a lock-out period is for one or two years.  After the lock-out period expires then the borrower can prepay the loan.  Lenders who have a lock-out period generally have yield maintenance for a prepayment penalty.

And there are some lenders that will allow you to pay down up to 20% of the loan balance in any given year without incurring a prepayment penalty.  If your goal is to pay off the loan as soon as possible this is a perfect prepayment option to have.

Two Questions to Answer to Get the Right Prepayment Penalty

Now that you know the basics on prepayment penalties you’re now ready to make two important decisions about financing.  The first question you have to ask yourself is, How long do I plan to own this property?  If you really don’t know then go with a shorter fixed rate loan.  You’ll get the advantage of a lower interest rate and a prepayment penalty that will be less onerous if you plan to sell or refinance sooner than you ever thought you would.

The second question you have to ask yourself is, Do I really want to choose the loan quote with the lowest interest rate if it comes with an awful prepayment penalty?  Many times, the answer to this question is a resounding “no.”   As you can sense, not all prepayment penalties are equally bad.  Many times, that smokin’ interest rate comes with either a yield maintenance or defeasance prepayment penalty.

The Cost is Ginormous

The good news is that you don’t need to understand the definitions of yield maintenance and defeasance to make an informed decision (you can breathe a sigh of relief now).  All you need to understand is this very important point: YOU WILL NEVER, EVER PAY OFF A LOAN WITH YIELD MAINTENANCE OR DEFEASANCE.  Why?  Because the cost of the prepayment penalty is so egregious that no sane person would do it.  Even in the last year of the prepayment penalty, when the cost of prepaying the loan will be at its lowest, the cost is still prohibitive.

You may be wondering how expensive could it really be?  Unfortunately, you don’t have the ability to calculate a yield maintenance or defeasance prepayment penalty.  It’s that complicated.  Contact your existing lender to request an estimate of what it will cost to pay off your loan early.  But when they call you back with the answer, be sure you’re sitting down.  The cost is so absurdly high, that you won’t even be angry with the answer.  Astounded?  Yes.  Angry?  No.  You’ll just start chuckling to yourself.

My advice about prepayment penalties

My advice regarding prepayment penalties is simple.  Regardless of the type of prepayment penalty, make sure that it in no way impedes on your time horizon for refinancing or selling your property.  And under no circumstances should you get a loan that has yield maintenance or defeasance if you think there is even the remotest possibility that you want to sell or refinance your property before the loan comes due as the cost of the prepayment penalty will be so expensive that you won’t do it.  Don’t handcuff yourself with a prepayment penalty that has the potential of preventing you from making sound financing or investment decisions in the future for the sake of a slightly better interest rate or a longer fixed rate period.  It’s not worth it.