Prepayment Penalties 101

by A. Heinrich

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A Declining Balance is the "traditional" prepay penalty structure. With this structure, the borrower may repay the loan prior to the balloon by paying a penalty equal to a certain percentage of the loan amount, and this percentage declines over time. For example, for a loan with a 10-year balloon and a 25-year amortization, and 6.5% interest, the penalty might be calculated as:

Loan Amount: $5,000,000

At year five the borrower might have a window in which there is no prepay penalty, after which the declining balance would start over again. 1- to 3-months before the loan comes to term, the borrower might again be able to pay the loan off without penalty.

Declining balance penalties are still widely used by portfolio lenders?commercial banks and life insurance companies.

Two newer types of prepayment penalties are based on the idea that the lender should be completely insulated from any negative impacts of prepayment. According to a Yield Maintenance penalty, the borrower essentially must make up the difference between the amount of interest that would be earned on the loan if it were carried to term and the amount of interest that would be earned if the lender reinvested the borrower's prepaid principal in treasury securities of the same term. So, in the above example, repaying at the end of year 3, the total amount of interest that would be paid to the lender over the remaining 7 years of the loan term would be $1,976,057. The total amount of interest that would be earned with the $5,000,000 principal on a 7-year treasury security note?say, at 5%--would be $1,750,000. So the prepayment penalty amount would be $226,057.

The Defeasance Clause penalty was developed by CMBS Conduits as a way to control fluctuation in the assets that secure their securities issuances. Under this type of penalty, the borrower must provide the lender with treasury securities in the amount of the value of the mortgaged property. We might assume that a $5,000,000 loan has a 70% loan-to-value ratio, meaning that the mortgaged property is worth $7,142,857. The likelihood of a borrower being able to provide the lender with that amount in treasury securities for 7 years is fairly slim; so we can see by this example that prepayment is thus made extremely difficult if not impossible for most borrowers.

Prepayment penalties will often also involve a Lockout, which disallows prepayment under any circumstances for a period of time.

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