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Commercial Real Estate Loan Prepayment Penalties

Avoiding Commercial Loan Prepayment Penalties

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Borrowers are looking for the security of long term fixed rate commercial loans but are balking at the prepayment penalties that come with them. But do you really understand how these prepayment penalties work?

Why prepayment penalties?

First, prepayment penalties are based on the desire for commercial mortgage lenders to receive a level rate of return over the term of their investment. Thus if a loan pays off a loan early in a decreasing interest rate environment, the lender will receive a lower return than planned when it reinvests the money. 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.

Calculating the prepayment penalty

Most commercial mortgage 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 penalty 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

You can avoid prepayment penalties by accepting a one year adjustable rate loan. These loans typically do not contain prepayment penalties. However, adjustable rate loans do provide additional risk for the borrower.

Plan the term of the loan to coincide with divestiture plans. Thus, if you selling the property within five years you should have the loan mature in five years.

Request an assumption clause in the note. Most lenders will accommodate this request with the caveat that the new borrowers will have to qualify for the loan. The assumption of the loan means there would be no prepayment penalty.

With careful planning on the part of the borrower, loan terms can be established in the borrower's favor. If there is a financial gain to be had for a quick sale of the property, the sales price should reflect the cost of the prepayment penalty.