A prepayment penalty is a fee lenders charge when a borrower pays off a loan early based on a predetermined timeframe. While this may feel unfair to a borrower, you must remember that lenders are trying to make a living just like everyone else. They can be kind-hearted, but they, too, must make enough money to pay their bills and take care of their families. Loans are structured to earn a financial return over time—called a yield maintenance requirement. If a borrower pays off the loan early, that return drops. A prepayment penalty helps to offset the lost income.
In California, prepayment penalties are not allowed on many owner-occupied single-family home loans. They are, however, allowed on investment property, commercial and industrial property, and raw land. Prepayment penalties vary, just as the terms on loans do. It’s up to the lender and borrower to come to an agreement that feels doable and fair. The lender is compensated for tying up their money and the borrower gains access to funds needed to invest in the property.
Most financial transactions come with an element of risk. You may have heard of the risk-return trade-off: the higher the risk, the higher the potential gain (or loss). Given that it’s impossible to predict interest rates, fixed-rate loans put lenders at a significant disadvantage if they do not have a prepayment penalty. If interest rates fall and the borrower refinances to get a lower rate, the lender loses their source of income on that loan. If rates go up, the lender loses the ability to charge more.
One standard prepayment penalty requires the borrower to pay six months’ worth of interest on anything pre-paid in excess of 20% of the balance of the loan. Let’s say you have a $100,000 loan with a two-year prepayment penalty. To calculate the cost of the prepayment penalty for paying off the loan today, deduct 20% from the $100,000 loan balance, which leaves $80,000. If the loan has a fixed interest rate of 7%, one year’s worth of interest on $80,000 would be $5600. Half of that is $2800. So, if you paid the loan today, you’d pay the remaining loan balance plus $2800.
Sometimes prepayment penalties are added to seller-carryback loans (loans where the seller acts as the lender). In this case, instead of a buyer sending a monthly mortgage payment to a bank, they send the payment to the seller. These arrangements are more common for properties that conventional loans don’t cover, such as raw land or a fixer upper. Seller financing is also more common when borrowers don’t have enough reportable income, a down payment, or a credit rating that makes them a reliable risk in the eyes of conventional lenders.
Seller financing doesn’t just benefit the borrower. It is a way for sellers to spread their capital gains tax liability over several years rather than realizing the income from the sale all at once. It also allows the seller to divest an asset and gain predictable cashflow. If structured properly, the loan payment can coincide with the seller’s need for cash, as in the case of a balloon payment at the end of loan timed to pay for college tuition for the seller’s twins as they head off to college.
As a reminder, capital gains is not calculated by subtracting the outstanding loan from the sales price. It is the sales price minus a property’s basis (the basis is the original sales price plus the value of capital improvements minus depreciation). The capital gains amount may be in excess of the loan amount, which means your tax liability could exceed your equity in the sale. In plain terms, selling your property could cost you money.
With seller financing, buyers and sellers can get creative to minimize the seller’s capital gains tax and provide benefits to the borrower by raising the sale price of the property and ditching the prepayment penalty. This is because capital gains and ordinary income are taxed differently. Stay with me here.
If a property is worth $1 million and sold for $1.35 million, the $350,000 bump on the purchase price acts as a prepayment penalty. The seller pays capital gains on the$350,000 but pays no ordinary income tax. Also, the buyer’s basis is higher, so the buyer reduces or avoids capital gains taxes when they eventually sell, as well as benefiting from higher depreciation.
As always, I write this column as food for thought, not advice. Each transaction is different. I simply provide ideas for you to discuss with your real estate professional, tax professional, and legal professional. They are the experts on your particular situation.
If you have questions about property management or real estate, please contact me at [email protected] or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery. To see previous articles, visit www.selzerrealty.com and click on “How’s theMarket”.
Dick Selzer is a real estate broker who has been in the business for more than 45 years.
