Borrowers are looking for the security of long term fixed rate loans but then balking at the prepayment penalties that come with them.
But do borrowers really understand how these prepayment penalties work?
First, prepayment penalties are based on the need for lenders to receive a level rate of return over the term of their investment. Thus if a loan pays off in a decreasing interest rate environment, the lender will receive a lower return than planned. As any investor knows, this is not good.
Since it is unrealistic to assume that no loans will prepay, the prepayment penalty is designed to give the lender a level rate of return. If rates go up, the lender is happy to get the prepayment since the lender can now reinvest at a higher rate. But if rates are lower, the penalty kicks in.
Most lenders use Treasury notes as the index for their interest rate computation. A five year term loan will be matched with a five year treasury. Typically a commercial loan will be indexed at 300-400 basis points over the like term Treasury note.
And when it comes to the prepayment penalty, the same index is used. For example, when a ten year fixed rate loan pays off after five years, the prepayment will be based on the remaining five years.
The lender will calculate the remaining balance of the loan and the income that will be lost on that loan. By comparing the difference between the yield on the loan and the yield on a five year treasury note, the lender determines the penalty.
The actual penalty is calculated as the present value of the difference between the two streams of payments. Thus, if the lender is going to get $30,000 less over five years, the present value is $23,800 and that is the amount the borrower will be expected to pay as the prepayment penalty.
Avoiding Prepayment Penalties
1. Accept a one year adjustable rate loan.
2. Plan the term of the loan to coincide with divestiture plans.
3. Request an assumption clause in the note. Most lenders will accommodate this request with the caveat that the new borrowers qualify for the loan.
Experienced, nationally published writer with twenty five years of banking, mortgage banking, and real estate experience. Academic background as adjunct college instructor and course developer. BSBA, MBA. Former bank president and chairman of the State of Florida Investment Advisory Council.
Publication includes multiple articles in the Christian Science Monitor, Bank Director Magazine, American Banker, Credit Union Business, Independent Banker, Financial Freedom Quarterly, National Mortgage Broker, Mortgage Originator, Mississippi, Florida Realtor, Florida Times Union, the Miami Herald, the Ft. Lauderdale Sun Sentinel and a column in the Palm Beach Post called “Mortgage Plain Talk. " See my website for many more informative articles about mortgages: http://www.mortgage-smart.info