The Prepay Penalty: the Borrower’s Burden
We’re getting ready to refinance our building’s underlying mortgage, and every loan we’ve looked at has a yield maintenance prepayment penalty like the one on our existing loan. Can’t we get a loan without a prepayment penalty, or at least one with a penalty that’s less onerous than yield maintenance?
With very rare exception, all underlying mortgages have prepayment penalties. Many people think that this is unfair and that every borrower should be able to repay the loan whenever the borrower wants without penalty. From the borrower’s perspective, free prepayment makes perfect sense. However, from the lender’s point of view, it does not. To be fair, if the borrower can prepay whenever interest rates go down, then the lender should be able to demand loan repayment whenever interest rates go up. Most borrowers would strongly object to that.
The logic behind prepayment penalties is a little easier to understand if you think of a loan as an investment or a contract. Under a loan agreement (usually referred to as the “note”), a lender agrees to provide the borrower with a certain amount of money (the “principal”) for a specified period of time (the “term”) in exchange for a rental fee (the “interest”). This is much like an investor who buys a certificate of deposit (CD) from a bank, expecting to receive a fixed amount of interest until the CD matures. If, prior to the CD’s maturity date, the bank were to cancel it and return the investor’s money, the investor could rightfully expect some form of compensation (or penalty) from the bank for breaching the agreement.
When a borrower closes a loan, he or she enters into a contract with the lender, and this contract comes with certain rights and obligations for each party. The borrower has the right to use the lender’s money for the duration of the loan term and the obligation to make the required payments of interest (and sometimes principal) when they are due. The lender, having made an investment in the borrower, has the right to expect the rate of return that was specified in the contract (i.e., the interest rate) for the duration of the loan term. If the borrower decides to breach the contract by prepaying the loan before the maturity date, the lender is entitled to compensation in the form of a prepayment penalty.
Most banks are in the money business, receiving money in the form of customer deposits (for which they pay a rental fee or interest) and disbursing money in the form of loans (for which they collect a rental fee or interest). A typical bank’s survival depends on maintaining a positive spread between the interest it collects from borrowers and the interest it pays out to depositors. This balancing act is easier when market interest rates are stable, but it becomes more difficult when they are not. As interest rates rise, many depositors cash in their lower-rate CDs to reinvest in something that pays them a higher return. When interest rates fall, many borrowers prepay their loans to refinance at a lower rate. CD cancellation fees and loan prepayment penalties help banks cover the costs of these disruptions.
In today’s underlying mortgage market, not every loan has a yield maintenance prepayment penalty. I am old enough to remember when the choice for most co-op boards looking for a new underlying mortgage was either a five-year balloon loan with one five-year renewal option, or a thirty-year self-liquidating loan. The five-year loans typically had prepayment penalties based on a declining percentage of the outstanding loan balance (e.g., 5 percent in the first year, 4 percent in the second, 3 percent in the third, 2 percent in the fourth, and 1 percent in the fifth). This schedule is repeated if the borrower exercises an option to renew the loan for a second five-year period.
The thirty-year loan usually prohibited prepayment (or imposed a yield maintenance penalty) for the first fifteen years. After that period, the prepayment penalty dropped to one percent of the outstanding balance or, in certain cases, zero. By the time I started my mortgage brokerage firm, about twenty-five years ago, more lenders had entered the market with intermediate products of ten or fifteen years. Unfortunately, almost all of them adopted yield maintenance as their prepayment formula. However, many boards were so happy to have an intermediate-term alternative to the five- and thirty-year loans that they overlooked the yield maintenance prepayment penalty. In fact, the ten-year maturity soon became the most common form of underlying mortgage, accounting for more loans than all the other maturities combined. That continues to be the case today.
While yield maintenance remains very prevalent in underlying mortgage loans, competition among lenders has resulted in a number of interesting alternatives. For a new ten-year loan, some lenders might impose yield maintenance for the first five or seven years and then switch to a declining percentage. Other lenders have abandoned yield maintenance altogether in favor of a declining percentage formula for the entire term. Even if a lender offers you a loan with yield maintenance, you always should ask whether there is another option.
As a final note, I would like to mention that prepayment penalty formulas are relevant only if you have to prepay. Prudent financial planning, annual budgeting of contributions to the co-op’s reserve fund, and second mortgage credit lines can obviate the need to prepay an existing underlying mortgage for most buildings. And, when interest rates are very low (as they are now), go for the best interest rate regardless of the prepayment penalty formula, because the likelihood of higher rates should you have to prepay is extremely low.