In commercial real estate loans, a prepayment penalty is a fee charged to borrower if they attempt to repay their loan early. When a lender issues a loan, they typically want to lock in their profit for a certain amount of time, so the prepayment penalty is a way to compensate them for their financial loss if the loan is paid off early.In this article:
Taking out a commercial loan for your business can be a great way to get the financing you need. However, commercial loans often come with prepayment penalties that can catch borrowers off guard. In this comprehensive guide, we’ll explain everything you need to know about prepayment penalties on commercial loans.
What is a Prepayment Penalty?
A prepayment penalty is a fee that some lenders charge when you pay off your loan early It compensates the lender for interest they would have earned had you kept the loan until maturity
Prepayment penalties are common with fixed-rate loans where the lender locks in an interest rate. If you refinance when rates drop the lender loses expected interest. The prepayment penalty helps make up for this loss.
Why Do Lenders Charge Prepayment Penalties?
There are a few key reasons lenders charge prepayment penalties:
- To discourage refinancing when interest rates drop
- To recover origination costs if the loan is paid off too quickly
- To ensure a minimum return on investment
Without prepayment penalties borrowers could refinance as soon as rates decline leaving the lender with unrecouped costs and minimal interest earnings.
What Types of Commercial Loans Have Prepayment Penalties?
You’ll commonly find prepayment penalties on:
- Conventional commercial mortgages
- CMBS loans
- Life insurance company loans
- SBA 7(a) loans
- USDA loans
- HUD/FHA loans like 223(f) and 221(d)(4)
Generally, fixed-rate loans have prepayment penalties while variable-rate loans do not. However, it’s wise to verify if a penalty applies to any commercial loan you’re considering.
Examples of Prepayment Penalty Structures
There are several ways lenders can structure prepayment penalties. Common examples include:
Lockout Period
With a lockout, you cannot prepay the loan at all for a set period. For example, a 5-year lockout means you cannot prepay until year 6. Lockout periods can last anywhere from a few months to 10+ years.
Declining Penalty
Also called a step-down penalty, the fee declines over time. For example, a 5% penalty in year 1 decreases by 1% each year thereafter. By year 5, there is no penalty.
Fixed Percentage
You pay a set percentage of the loan balance, such as 5%, whenever you prepay. The percentage stays fixed but the penalty amount declines as the balance goes down.
Yield Maintenance
The penalty equals the lender’s lost interest, factoring in reinvestment rates and the remaining term. This maintains the lender’s expected yield.
Defeasance
Replacing the collateral with government securities maintaining the lender’s return. Complex and expensive.
When Does the Prepayment Penalty Apply?
A prepayment penalty typically applies if you:
- Refinance the loan
- Pay off the loan in full before maturity
- Sell the property and repay the loan early with proceeds
This is usually limited to the penalty period, such as the first 5 or 7 years of the loan. Penalties don’t apply after this set timeframe.
How Can I Avoid the Prepayment Penalty?
Here are some tips for avoiding prepayment penalties:
- Take a variable-rate loan without a penalty provision
- Find a lender that offers prepayable options
- Negotiate a lower penalty or shorter penalty period
- Wait out the penalty period before refinancing
- Structure your business exit strategy around the penalty timeframe
You may also look for assumable loans that let you transfer the collateral without prepaying.
Are Prepayment Penalties Negotiable?
In some cases, yes. You may be able to:
- Shorten the penalty period
- Get a lower fixed percentage penalty
- Switch to a more favorable penalty structure
- Make the loan assumable
Your negotiating power depends on your financial profile, the lender, and market conditions. It never hurts to ask!
How Do I Calculate the Prepayment Penalty?
The lender calculates the exact penalty amount. Fixed percentage and step-down penalties are straightforward – it’s a percentage of the outstanding principal.
Yield maintenance and defeasance are complex and require factoring the lender’s reinvestment rate, lost interest, and more. Work with your lender to understand the costs before prepaying.
How Much Will the Penalty Be?
It depends on the structure, your balance, and other factors. Fixed percentage penalties on a $1 million loan balance could cost you $20,000 – $100,000. Step-downs average around 7% of the balance. Defeasance and yield maintenance vary widely.
Ask your lender for sample penalties at different points during the loan so you know the potential costs.
When Does it Make Sense to Prepay?
If rates decline significantly, prepaying makes sense once the penalty period ends. It may also make sense if you’re selling the property or if the penalty is negligible relative to interest savings.
Conversely, it rarely makes sense to prepay during lockout periods or when the penalty outweighs interest savings. Do the math with your lender to see if it works for you.
How Can I Get a Commercial Loan Without a Penalty?
Options for avoiding prepayment penalties altogether include:
- Asking lenders if they offer prepayable loans
- Taking a variable-rate loan without a penalty clause
- Getting a loan from a community bank or credit union
- Exploring alternative lenders like P2P platforms
Loan programs like SBA 504 and USDA B&I loans don’t have prepayment penalties. But availability is limited.
Key Takeaways on Prepayment Penalties
Prepayment penalties help lenders maintain their yield but can create headaches for borrowers. By understanding how they work, you can make informed financing decisions:
- They compensate lenders for early repayment
- Lockout, declining, fixed percentage, yield maintenance, and defeasance are common structures
- Always verify if a penalty applies and estimate the costs
- Weigh interest savings vs the penalty when considering prepaying
- Shop around for prepayable options or negotiate the terms
While annoying, prepayment penalties aren’t dealbreakers if the loan works for you. Know the potential costs upfront so you can plan accordingly. And consult professionals like CommLoan for guidance on commercial loans and prepayment penalties.
Step Downs vs. Soft Step Downs
After the lock out period (if there is one), a borrower can often pay off their loan for a certain percentage of the loan amount. If the percentage declines year by year, for example, 6% in the first year, 5% in the second year, 4% in the third year, and so on, this is called a step down prepayment penalty.
In comparison, some loans have a soft step down prepayment penalty. These usually start lower and decline more slowly. For example, instead of the 6-5-4-3-2-1 step down in the example above, a loan might have a 4-3-3-2-2-1 soft step down penalty.
What is a Prepayment Penalty in Commercial Real Estate?
In commercial real estate loans, a prepayment penalty is a fee charged to borrowers if they attempt to repay their loan early. When a lender issues a loan, they typically want to lock in their profit for a certain amount of time. Basically, the prepayment penalty is a way to compensate them for their financial loss if the loan is paid off early.
Prepayment Penalties in Commercial Real Estate lending
FAQ
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