Prepayment Penalties

March 19, 2014

Prepayment penalties are an oft overlooked yet essential element when assessing the financing of a commercial property. Understanding this key factor can have a major impact on the benefit of your loan. This summary breaks down the different types of prepayment penalties offered by lenders in today’s market.

1) Yield Maintenance: The yield maintenance prepayment penalty is the most common penalty that exists in insurance company loans. Insurance companies invest in commercial mortgage loans as an alternative investment to high quality bonds. These kinds of bonds do not payoff early, so mortgage loans are structured to mimic the footprint of long term insurance policies. A yield maintenance penalty allows these lenders to collect a yield equal to the borrower’s scheduled mortgage payments through the maturity of the loan. The premium is calculated based on the difference between the rate of the note and the interest rate of the closest matching bond maturity, multiplied by the remaining term on the loan. Typically these are longer term fixed rate loans, and usually have lower fixed interest rates.

2) Defeasance: By definition defeasance is a substitution of collateral. A defeasance is typically associated with CMBS loans. Conduit loans are securitized or sold as bond offerings and cannot be paid off. One can defease a loan by hiring a defeasance company to purchase bonds and process through the substitution of collateral. Be conscious of transaction costs and low yield from bonds in this scenario.

3) Step Down: A step down prepayment penalty is typically offered by banks, and occasionally an alternative offered by insurance companies. The term step down simply refers to a declining prepayment penalty over the term of the loan. For example: a 5-year fixed term could have a 5%, 4%, 3%, 2%, 1% penalty, declining by 1% per loan year. A step down prepayment penalty is generally the most flexible, but is commonly associated with shorter term fixed rate loans.

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