I Prefer to Prepay

There is a debate raging in our building about refinancing the underlying mortgage. Some shareholders boast about the low rate they got refinancing their apartment loan and insist that we should do the same with our building’s loan. Others think that we should wait because rates seem to be headed even lower. Our managing agent tells us that our existing loan has a large prepayment penalty until the middle of next year. Everyone wants the savings from today’s (or tomorrow’s) lower interest rates, but no one wants to pay the penalty. But, if rates go up before our penalty goes away, we could be worse off. What should we do?

That’s literally the $64,000 question. In fact, depending on the size of your existing loan, it could be a much more expensive question. It’s also one that lots of people are asking these days. And the answer, as it is in so many cases, is: “It depends.”

Let’s address the prepayment penalty first. Many shareholders have an emotional block against prepayment penalties. They feel that an evil lender snuck the penalty into their loan documents and, under no circumstances, will they give them the satisfaction of collecting it. Such nonsense makes for spirited debates at shareholder gatherings, but it’s just that: nonsense. Another myth is that some loans don’t have prepayment penalties. For the record, virtually all underlying mortgage loans have some sort of prepayment penalty. Then there are those who think that they can get a lender to waive the prepayment penalty. In rare instances, a lender might grant some reduction, but don’t bank on it.

A loan note and mortgage are contracts between the lender and the borrower. Neither side can break the contract without the consent of the other, regardless of changes in the market or other factors. For example, if interest rates go up, the lender can’t break the contract and charge a higher rate. Likewise, if rates go down, the borrower can’t cancel the deal to get a lower rate. However, a lender might allow a borrower to break the contract in exchange for a fee, and this fee has the perhaps unfortunate name of “penalty.” Remember: all of this was disclosed in the original loan documents, which both sides signed at closing. There is nothing unfair, unethical, underhanded, or illegal about it.

For most loans originated over the last ten years or so, the fee to prepay a loan is calculated to equal the present value of the interest income that the lender will lose if the borrower breaks the contract and prepays the loan. For example, if a building had a $2,000,000 loan for 10 years at seven percent (and let’s assume that the loan is “interest only” for simplicity), and the board decides to prepay the loan at the end of year six. This will deprive the lender of interest income for the four years remaining in the original loan term. When the borrower prepays, the lender will take the $2 million and invest it in U.S. Treasury securities that have a four-year maturity and an interest rate of, say, two percent to make up part of that lost interest income. So, the net loss suffered by the lender will be the seven percent less the two percent, multiplied by the remaining four years of the loan, adjusted by the time-value of money…about $384,000! Ouch!

So, why would anyone ever prepay a loan? Because, in some instances, they can save more than the penalty by replacing their existing loan with a new loan at a lower interest rate. And how much lower does that new rate have to be? There is a frequently quoted rule-of-thumb that says that the difference between the old and the new rates must be at least two percent for refinancing to make sense. Unfortunately, that frequently quoted advice is frequently wrong. The correct answer requires a calculator and some serious number-crunching. In most cases, the numbers must show that the penalty can be recouped in less than four years for prepayment and refinancing to be justified (on a ten-year loan…it’s sooner for a five- or seven-year loan).

Let’s go back to our example. The penalty for prepaying our $2 million, seven-percent loan four years early was about $384,000. The new interest rate would have to be something less than two percent for refinancing to make sense. So, if this were your building, you would have to wait until the loan was closer to maturity before refinancing. The actual numbers for your building lead to a similar conclusion because you would need a little longer than seven years to recoup your prepayment penalty…too long to make refinancing now worthwhile.

However, that doesn’t mean that you can’t take advantage of today’s low interest rates. Since your existing loan matures in less than one year, some lenders will give you a “forward commitment” for a new loan. A forward commitment allows you to lock in an interest rate today for a new loan that will close sometime in the future. To get a forward commitment, you apply for a new loan in the usual manner. If the lender approves your application, they will issue a commitment that specifies both an interest rate and a closing date in the future.

The interest rate for your new loan will be higher than it would be for a loan closing now. The forward premium added to today’s rate ranges from 6 to 10 basis points (0.06% - 0.10%) per month of advance rate lock. Since your existing loan does not come due until the middle of next year, the interest rate on a forward commitment for a new loan would be 50 to 90 basis points (0.50 percent to 0.90 percent) higher than today’s rate. This premium is not insignificant but, since current rates are so low, the actual rate you could lock in today would be very attractive compared to your existing rate. And, by taking a forward commitment today, you absolutely avoid having to pay the prepayment penalty because you won’t actually close your new loan until after the penalty has expired.

However, before making any decisions regarding a refinancing of your existing loan, you should meet with all of your professional advisers – your managing agent, accountant, and attorney – to discuss the potential impact on your cooperative. Refinancing is a complex and expensive process that will affect not only your monthly maintenance but also the market value of every shareholder’s apartment. Your advisers have experience with other cooperatives in similar situations and can help guide you to the right choice for your building.