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Prepayment Penalties: Step-Down vs. Yield Maintenance

Diligent Real Estate Investors should always go into an investment with a detailed disposition plan. Most times these exit strategies involve the investor(s) holding the property for 3 to 5 years and then either selling or refinancing. The timeline of when the property will be sold or refinanced is a very important detail to understand, but in this week’s blog, we are going to cover a detail that may not stand out: Mortgage Prepayment Penalties. This a crucial piece to the puzzle that may factor into how long you hold the property. A loan prepayment is a penalty that you, the investor, must pay to the lender for paying off the mortgage before the loan term comes due. Also, these penalties are usually only assigned if the loan is paid off within the first 5-years, however; this is all contingent on the negotiated terms of the loan. Below we will talk through the two main types of prepayment penalty structures for commercial loans. Step-Down: The way that this prepayment penalty is structured is through a declining or “step-down” method based on how early you sell or refinance the property. How the Step-Down prepayment penalty is structured would be a 5-4-3-2-1 which means that if you pay off the mortgage in year 1 then you will pay 5% of the remaining loan amount all the way down to year 5 when you would only pay 1%. Now, there is another very similar structure called a soft step-down. An example of this structure would be, 3-2-2-1-1. This would also follow the same logic as above. This is a favorable structure since you know exactly what you are signing up for and can forecast more accurately. Yield Maintenance: The structure of this prepayment penalty is designed by the lender so that they are reimbursed for lost interest payments that they would have received had the borrower not paid the debt off early. Investors choose to go with Yield Maintenance because lenders will usually provide better terms for the loan. Also, the prepayment penalty may be very low if interest rates begin to rise when the property is sold before the loan matures. If interest rates have gone up, then the lender will usually only assign a 1% prepayment penalty to the borrower since it would be more advantageous for the lender to reinvest in a high-yielding loan. The problem with Yield Maintenance is the chance that interest rates could remain stagnant or decrease. If interest rates have declined in the market at the time of sale or refinance (before the loan has matured) then the lender will want to be compensated for that. The reason is because now the lender will have to go reinvest that money at a lower interest rate compared to what the loan had been yielding. If this is the case, then the lender uses a formula to calculate the prepayment penalty. How this works is that the lender will find the present value of the remaining loan payments and multiply that by the difference between the loan’s current interest rate and the current treasury rate that is of the same duration as the original loan. This can lead to steep prepayment penalties. Conclusion: Understanding the details of both Step-Down and Yield Maintenance will be helpful the next time you are choosing financing terms. It is crucial that you have the exit strategy in the front of your mind so that you can pick which loan structure will work best for you and your investment strategy.

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