"5-4-3-2-1" ... A Countdown Mortgage That Can Save on Prepayment Costs

The financing provided by a new mortgage should be supplemented with a line of credit taken out at the same time as the mortgage, along with insurance. "Many underlying mortgages offered to co-ops won't permit a secondary or 'junior' secured mortgage, or an unsecured line of credit. So, if something comes up, and you need more money suddenly, the co-op could really be stuck without the availability of such additional loans," attorney Arthur Weinstein says.

Should a co-op choose to refinance its loan at a lower interest rate and pay the old one off early, there is likely to be a gain that may not be obvious: one-time tax deductions. Since interest paid off in advance is deductible, co-ops may be due for a one-year lump sum interest write-off.

Captain Quirk

That deduction is made even bigger by a quirk common in co-op building loans: many 10-year loans call for a schedule of interest amortization based on a 25-year mortgage life with a balloon interest payment at the end. That's a big cost. But David Lipson, director of Century Management's mortgage division says the lowered interest rates may justify refinancing in spite of the sometimes seven-figure penalties applied.

 Before considering such a move, though, Lipson says that co-op boards must not only figure out how much such a change will cost and how much would be saved, but it must also undertake a thorough review to determine what its future capital needs will be.

The amount of the penalties is dependent on the specific strictures written into the mortgage agreement. Generally, prepayment penalties divide into two categories: those focused upon yield maintenance and "5-4-3-2-1" agreements. In Goodman's words, yield maintenance penalties can be "formidable." Weinstein says these terms can be "killers."

Down for the Count

Less restrictive are the "5-4-3-2-1" mortgages. Characteristically, this type of loan covenant calls for a penalty of 5 percent additional interest cost for early repayment in the first two years of the loan, 4 percent in the next two years, 3 percent in the fifth and sixth years, 2 percent in the seventh and eighth years, and 1 percent in the ninth and tenth years. These terms are negotiable and vary from loan to loan. Further, Weinstein points out, it's sometimes possible to get the penalties knocked out entirely for the final three or even six months.

Understandably, since these penalties drop away as the loan nears its termination, a great many of the refinancing deals now taking place happen in the ninth or tenth years of ten-year deals. 

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Adapted from "Solving the Prepayment Puzzle" by Jonathan Leaf (Habitat, September 2014)