How Prepayment Penalties Work
Lenders provide financing secured by commercial and investment real estate to make money (returns). In order to guarantee their own returns, banks and private lenders use prepayment penalties to ensure they see the interest rate returns the need. When a borrower pays back a loan early it can affect the ROI for the lender if no prepayment penalty is in place.
Commercial mortgage lenders utilize a Prepayment Penalty. If the borrower pays the lender back before the pre-determined time outlined within the prepayment penalty terms and conditions, the borrower will not only pay off the outstanding loan principal. but will also be charged a fee for paying off the loan early.
Types of Prepayment Penalties
When a loan is prepaid before maturity, the lender calculates the net present value of the interest they would have received had the loan been held to maturity, maintaining their yield/profit from the loan.
Also known as “Step-down”, the lender agrees to a simple schedule of prepayment penalties, often stated year by year. So for a 5 year loan, the schedule might be 5,4,3,2,1, with a few months at the end of the loan where there is no penalty.
A step-down is one kind of a prepayment penalty on an existing commercial mortgage or other commercial property loan. Lenders typically impose a prepayment penalty on all financial products that create a creditor-debtor relationship. As the creditor, the lender relies on the terms of the original loan to predict a return on investment.
As insurance against that loss of revenue, commercial mortgage lenders may include a step-down clause in the mortgage contract. Generally, this is a straightforward calculation based on the remaining balance. It is called a "step-down" penalty because the amount gets smaller the longer the loan is in place.
For example, a typical step-down might be 5 % of the outstanding balance in the first year, 4% in the second year, 3% in the third year, and so on. Most lenders will not charge a step-down penalty in the last 90 days of the loan term.
It’s impossible to prepay. This would more commonly be a period of the loan, usually early on, rather than the whole term.
Defeasance is used to prepay a CMBS loan (where the loan is cut up into bonds and sold on the open market), but explaining this one would be a longer subject. Suffice it to say, prepaying a CMBS loan through defeasance isn’t cheap or easy, so it’s rarely done.
Most bridge and hard money lenders do not charge a prepayment penalty, or offer loans with no prepayment penalty after 3-4 months.
Negotiating prepayment penalties
The prepayment penalty for a given commercial loan is typically negotiated at the front end when a lender provides a Letter of Intent or Term Sheet. Prepayment penalty terms and conditions are lengthly, and in some cases can be negotiated.
Most bridge loans do not have a prepayment penalty while permanant loans usually do.