You may have heard you can save a bundle of money by paying off your mortgage early. Have you ever asked yourself, “If I’m saving money, who is losing money?” Well, the answer is: your lender. Sometimes, especially with big commercial properties, lenders protect themselves against early payoffs by including pre-payment penalty clauses in their loan agreements.
Many lenders insist on pre-payment penalties to ensure their continued yield over a period of time. This allows them to cover their expenses, since their up-front fees to arrange the loan do not always cover the cost of doing the work. I’m sure you’ve seen the ads promising, “Refinance with us and we’ll pick up all the costs!” In some cases, that means lenders not only pay the title and escrow fees (and related transaction costs), they also pay the loan origination fees, which can add up to 1-2 percent or more of the loan amount.
If that loan is paid off in the first year (instead of over the course of 15 years), the lender will have suffered a significant loss. A friend of mine who does private party, owner occupied loans argues vehemently that his cost to put one new loan on the books is about $7500; and that doesn’t include the escrow costs, title insurance, or the drawing and recording of documents. In those situations, he’s not allowed to charge a pre-payment penalty. Consequently, he either charges an up-front fee to cover his costs or he assesses the situation carefully so he can be confident the loan will stay on the books long enough for him to recoup his costs.
Pre-payment penalties can take many forms. Typically, they are calculated based on some time frame for which the buyer is required to pay interest. If the loan is paid down or paid off early, the lender charges the penalties. In many cases, the lender will only accept a full pay off the loan if the payment includes the remaining principal plus 4-6 months’ worth of interest.
Most lenders hide pre-payment penalty details in plain sight. All pre-payment penalties must be clearly outlined in the loan agreement, but reading through the verbiage and understanding it might require a law degree and a finance background, especially if you want to negotiate on this point.
Although I said “plain sight,” many of the people who read the pre-payment penalty clause don’t know what they’re looking for. It may be referred to as a “yield maintenance provision” or similar title. And like I said, even if you know you should be paying attention, this stuff is dry; I call it bedtime reading (that is, if you’re trying to fall asleep).
The short story of yield maintenance provisions is this: the lender wants to be sure their investment is protected and their long-term yields will be realized. So if your 30-year loan was written at 8 percent ten years ago and you want to refinance it today at 5 percent, the lender will require a penalty of 3 percent of the loan amount times 20 years. Most of us will never experience a yield maintenance provision pre-payment penalty as they are fairly exclusive to very large commercial loans. However, this is the prime example of why it is so important to READ YOUR LOAN DOCUMENTS.
Pre-payment penalties are a negotiable item and many times a lender will be willing to forego (or reduce) a pre-payment penalty in return for a higher interest rate, a lower loan-to-value ratio, or a higher up-front fee. But if you don’t read your loan documents, you won’t know about the penalties. If you don’t know about the penalties, you won’t know you need to negotiate.
If you have questions about real estate or property management, please contact me at rselzer@selzerrealty.com or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 40 years.