What is a Prepayment Penalty?
A prepayment penalty is the fee a lender charges a borrower, who pays off their loan before it’s due. In other words, it is an early termination fee, or penalty imposed on borrowers should they decide to pay off their loan before it matures.
Prepayment penalties are common in most types of loans, both business and consumer, making it imperative for business owners and real estate investors alike to know what they are, where to find them, and ways to avoid paying them altogether.
Why Do Prepayment Penalties Even Exist?
Prepayment penalties exist simply to protect a lender against financial losses. A lender generates income from interest collected over the time of a loan, whether it is a year, several years, or even decades. Therefore, a borrower that decides a month after a loan has funded to return all the money, presents a problem for lenders, as that can be years of income lost. Not to mention the internal time, energy and money lost setting up a loan that ends so soon. In this respect, prepayment penalties can act like a severance package; they compensate lenders for their time should the borrower decide to part ways sooner than expected.
What Triggers a Prepayment Penalty?
There are two main events that can trigger a prepayment penalty, either 1) repayment of the loan in full or 2) large partial repayments of the loan within a certain time period.
Full repayment of a loan involving real estate or physical assets, commonly occur on the sale of the property or refinance of the loan. In the case of general business and commercial loans, a new investor may bring in additional capital that is used to payoff the loan in full.
Partial repayment of a loan is usually staggered out over time. It can be an extra check at the end of the year, an additional $500 tacked onto to each monthly payment. Depending on the structure of the specific loan, partial payments of a substantial size will catch the lender’s attention and may trigger prepayment penalties.
Are Prepayment Penalties Legal?
Yes, prepayment penalties are legal, however can be subject to certain conditions and limitations, depending on the type of loan, what type of real estate (if any) secures the loan, and the state’s local statutes. While prepayment penalties for consumer mortgages have certain caps, and even prohibited altogether in a few states, prepayment penalties for investment and commercial loans are legal and the way of doing business.
What Types of Prepayment Penalties Are There?
Loans, particularly those secured by real estate, whether it is land, commercial or residential property, have two main types of prepayment penalties: soft and hard. In a loan that calls for ‘soft’ prepayment penalties, a borrower may sell the property without incurring a fee. Only when the borrower elects to refinance the loan will they be charged a prepayment penalty. Conversely, loans that have ‘hard’ prepayment penalties will charge borrowers in any circumstance, whether it is a sale or refinance. Hard prepayment penalties are generally more common.
How Much Are Prepayment Penalties?
While the actual cost of a prepayment penalty varies, depending on the lender’s preferences and the type of loan, the fees tend to follow the following five payment structures:
A Certain Number of Monthly Payments
Prepayment penalties can take the form of several months interest, due and payable if the loan is paid off within a certain time period. For example, let’s say you take out a $300,000 interest only loan at 10% interest for 5 years, and the loan docs call for a prepayment penalty of 3 months interest. At $2,500 a month, this means that should you sell the property before Year 1, you will have to pay not only the remaining balance, but also a prepayment penalty of $7,500. This is sometimes referred to as a lump-sum flat rate penalty, and is common in real estate hard money loans.
A Percentage of the Loan Balance
Prepayment penalties can also be charged as a percentage of the remaining loan balance. For example, if you have a commercial loan with a balance of $500,000, and have a 2% prepayment penalty, when you request to payoff the loan early, your lender will charge you an additional $10,000. This is a common strategy employed in investment and commercial loans, especially of a significant size.
Total Interest Due
There are also loans where the prepayment penalty charged is the total interest that would have been collected over the course of the loan. For instance, a manufacturer borrows $50,000 and according to the loan agreement, after 3 years, will have paid $15,000 in interest. If suddenly business picks up and the owner decides to pay off the loan early, the borrower will have to write a check for $65,000 equal to the loan balance and the full interest he would have paid had he kept the loan. This is most prevalent in merchant cash advances, discussed later in this article.
Lenders seeking to maintain the same level of profits, or yields, adjusted for inflation and interest rates, may charge borrowers yield maintenance premiums. If you recall, prepayment penalties are all about compensating lenders for the income lost if a loan is paid off early. Under this fee structure, lenders take it a step further, by charging borrowers for profits lost, or the difference between the total interest due on the loan and what they could made somewhere else. U.S Treasury Bonds is a common baseline used. Through yield maintenance premiums, even in the face of an early payoff, lenders can net the same amount and retain their bottom line.
Cash Flowing Assets
More creative lenders may accept a cash flowing asset as valuable consideration to release a borrower from a loan early. Also known as defeasance, instead of charging a physical dollar amount as a prepayment penalty, the lender takes ownership of an asset that replaces the interest income received. With defeasance both sides can benefit. For a cash strapped borrower, it provides flexibility to use a resource they already have, as opposed to writing a check. For a lender, it allows them to remove a high-risk loan from their books, and get a safer investment that generates the same amount of interest. These, also, typically tend to be U.S. Treasury Securities.
What Types of Loans Have Prepayment Penalties?
If you are beginning your journey in business or in real estate with residential property in your personal name, your mortgage most likely has or will have prepayment penalties. For residential mortgages on properties with 1-4 units, Dodd-Frank, the 2010 federal overhaul of residential mortgage laws after the recession, capped prepayment penalties to 2% in the first two years, 1% in the third years, and 0% in the years following. Keep in mind, though, this only applies to mortgages originated after 2014.
It is safe to generally assume any loan for investment purposes will have prepayment penalties in some form. Whether it is a commercial loan, an asset-based loan, a working capital loan, a hard money loan, or a bank line of credit. Even 7(a) SBA loans for 15 years or longer have prepayment penalties within the first three years. (These are limited, though, to 5% in the first year, 3% in the second, and to 1% in the third year). If a lender says they don’t have any prepayment penalties, make sure to check your loan documents for ‘lender discharge fees’, or ‘early release fees’, and even ‘mortgage release fees’. These are all prepayment penalties operating under a different name.
Merchant Cash Advances
Merchant cash advances are commercial loans, in which the borrower pays off the loan balance as a percentage of future sales or invoices. For this type of financing, prepayment penalties are typically based off factor rates: a $100,000 cash advance borrowed at a factor rate of 1.4, will require $140,000 for full payoff. Unique to merchant cash advances, the prepayment penalty and full loan amount, or in this example $140,000, are due and payable at any point the borrower decides to pay off the loan in full, no matter if it’s the second day or the fifteenth month of the life of the loan.
How Do I Avoid Prepayment Penalties?
The most cost-effective way to avoid prepayment penalties is to negotiate them to terms favorable to you before signing the loan documents. Don’t be afraid to shop around and compare prepayment penalties across different lenders. This level of research and due diligence upfront can save you a lot of money down the line.
The second, and most simple, way to avoid prepayment penalties is to wait. Pay off the loan after the prepayment penalty period. Depending on the structure of the loan, the cost of a few more payments may be less than a prepayment penalty, and thus well worth waiting for the penalty clock to run out.
Whether you are a business opening a new location, purchasing new equipment, or developing your first project, commercial and investment loans open the door to exciting new opportunities. Now that you have a working knowledge of prepayment penalties, you put yourself in a much better position when in comes to choosing the lender and loan product right for you.