It is common to see prepayment penalties on commercial real estate loans, but what are they and what do they mean? Commercial real estate loans are expensive to originate, so lenders try to recoup these costs by charging upfront origination fees and interest revenue over the life of the loan. If a borrower decides to pay off the loan early, that anticipated revenue vanishes. To ensure the lender makes enough revenue on a particular loan, they will charge a prepayment penalty to ensure that they will get a set amount of revenue. The majority of the time you will see a prepayment penalty on a fixed rate loan and less so on a floating rate loan. The different prepayment penalties include lockout periods, step down, fixed, yield maintenance and defeasance.
Lockout Periods
A lockout period is when a loan cannot be paid in full during a set period of time. The borrower must wait until the lockout period expires before they can pay off the loan before maturity.
Step Down
Also known as a declining prepayment penalty, a step down prepayment penalty charges a percentage of the unpaid principal balance and then gradually is reduced as time passes. For example, a 54321 prepayment penalty is a 5% fee charged in the first year if an unscheduled principal payment or payoff is made, 4% in year 2, 3% in year 3, 2% in year 4, and 1% in year 5.
Fixed
A fixed prepayment penalty is a fixed rate that is charged to be able to pay off the loan before maturity. Something to keep in mind is that as the principal balance decreases over time, so does the amount of the prepayment penalty since it is calculated off the unpaid principal balance.
Yield Maintenance
Yield maintenance prepayment penalties protect the lender by ensuring they collect the original yield intended on the loan, in other words the present value of future interest the lender would’ve collected if the loan were carried through to the end of the prepayment penalty period. In an environment where interest rates are declining, this can be more costly for the borrower instead of a step down prepayment penalty. On the other hand, it can benefit the borrower and the lender if interest rates are rising as the lender can close on a new loan at a higher rate and the borrower can close a loan with less fees.
Defeasance
When interest rates are rising, defeasance offers the greatest flexibility. Defeasance is a technique for reducing the fees required when a borrower decides to prepay a fixed rate loan. Instead of paying the lender cash, the defeasance clause allows the borrower to swap another cash-flowing asset for the original collateral on the loan. This benefits the lender as they keep earning the same rate of return. The borrower benefits if rates are higher when the loan is paid off as they may be able to repay their loan at a discount.
How To Get Started?
Simple Commercial Capital is here to help you navigate all of the prepayment penalty options available. In some cases, prepayment penalties can be negotiated. Look through the loan programs found at the top of our page. Each program has a brief description and loan parameters. If one of the loan programs fits your needs click the Apply Now button to start the application process or call us at 1-866-554-1120 to discuss your options in more detail. Our goal is to make this process as simple as possible for you.