Everything they won't tell you about prepayment penalties

Real Estate Weekly, Nov 9, 2005 by Mark Yoffe

Prepayment penalties are fees that a borrower must pay the lender if the borrower decides to pay down or pay off the loan principal ahead of schedule.

There are several types of prepayment penalties: Sliding scale; Guaranteed interest; Yield maintenance; Defeasance; Lockout

A sliding scale prepayment penalty schedule, also called the graduated prepayment or, more appropriately, the declining percentage prepayment, is easiest to understand: the borrower is required to pay the lender a certain percentage of the amount being prepaid as a penalty. A prepayment penalty of 5-4-3-2-J, for example, means that the borrower must pay an additional 5% of the amount prepaid if the he or she wants to make any principal payments ahead of schedule during the first year. Similarly, if the borrower wants to make an extra principal payment during the second year, he or she needs to pay an additional 4% of the amount prepaid as a prepayment penalty. And so on.

The main advantage of the sliding scale prepayment penalty structure is that the penalties are simplistic, easy for most people to understand and, unlike some of the prepayment penalty schemes we will describe later, can be calculated with a minimum of arithmetic. The disadvantage of it is that that it makes no sense!

Does something magically happen to the real estate market on the first, second or third anniversary of the loan closing, that should make the prepayment penalty drop by a whole point?

Does it make sense to charge the same penalty regardless of what the prevailing rates on a new mortgage would have been?

The answer to all these questions is "no." So while the sliding scale prepayment penalty scheme is the most common and the most simplistic, it also the most arbitrary and lease sophisticated.

Guaranteed interest is seen frequently seen in interest only loans, such as bridge, hard money, and contraction loans. Under this scheme, the borrower is obligated to pay the interest for all or part of the loan term, regardless of whether or not the mortgage is paid off early. For example, a $1 million one year interest only mortgage with a rate of 12% might have guaranteed interest prepayment penalty of six months. That means that the borrower guarantees the lender at least $60,000 in payments (corresponding to 6 months x $10,000 per month). If the loan is kept for the full six months, then the $60,000 will been paid out monthly--$10,000 per month. If the loan is paid off before the six months, the borrower will have to pay $60,000 at payoff, minus any interest payments made to date.

A guaranteed interest prepayment penalty, combined with an interest reserve is fantastic racket. Think about the loan scenario we just entertained: you take out a loan according to the following terms and conditions:

Loan amount:             $1 million loan
Interest rate:             12%
Amortization:            Interest only
Monthly payment:   $10,000 (1% x $1 million)
Interest reserve:         six month interest
reserve ($60,000)
Prepayment penalty: guaranteed interest for 6
months (again, $60,000).

What happens next is this: $60,000 gets taken out of your $1 million loan--you only get $940,000 at the closing table. The rest gets placed into a real or fictitious account, controlled by the lender, from which monthly mortgage payments are made to the lender.

The lender keeps the sixty grand no matter what happens. If you keep the loan for at least six months, that money it gets paid out--from the lender's right pocket to the lender's left pocket--as interest. If, on the other hand, you pay the loan off early, the lender keeps the money as a prepayment penalty.

Either way, you'll never see the money--ever.

Yield maintenance is similar to the guaranteed interest prepayment penalty we just discussed in the sense that both forms of prepayment penalties require the borrower to compensate the lender for a loss of a future expectation of interest payment--or yield. However, yield maintenance is a little bit more sophisticated than that because guaranteed interest obliges the borrower to pay a fixed interest, while the yield maintenance penalty requires the borrow to pay a penalty that is proportionate to the yield, at the time of prepayment, of a specific security, frequently U.S. Treasuries. This prepayment penalty makes a lot of sense. After all, the lender's real loss is the yield which the borrower promised the lender; it is the yield which the borrower promised the lender, minus the yield that can be gotten by reinvesting the money in a readily-available and secure investment.

Let's use an example. Suppose borrowed $1 million exactly five years ago. The loan was for a 10-year term, a 30-amortization, a rate of 6%, and had a yield maintenance prepayment penalty. Your balance is $935,195.

If you prepay now, the lender loses because, presumably, the lender will have no place to invest your money, except in widely available and ultra-safe securities that mature in exact five years--in other words, 5-year Treasury bills. The problem with this investment from a lender's point of view, however, is that 5-year Treasuries are paying 4.5% per year (let's say), while the rate on your mortgage was 6%. So the lender is losing 1.5% (6%-4.5%) on amount prepaid for the next five years.