Prepayment Penalty Choices in the Era of Rising Interest Rates
Most commercial mortgages, particularly fixed-rate mortgages, have some sort of prepayment penalty. Lenders impose such a penalty to earn back some, or all, of the interest income they would have earned had the mortgage remained outstanding for its entire term.
Prepayment penalties generally come in one of three flavors: defeasance, yield maintenance or a percentage fee. For those of us who focus on financing multifamily properties, the last two options are what we will encounter most often as those are the options offered by the agencies (Freddie Mac and Fannie Mae).
How Do These Work?
The percentage fee prepayment penalty is the simplest to understand. With these terms in place, the lender simply charges the borrower a fixed percentage (for example, 2% or 1%) of the outstanding principal balance of the loan at the time of repayment. For example, if you have a loan with a 1% prepayment penalty which has amortized down to a balance of $5,000,000 you will have to pay an additional $50,000 to the lender when paying off the loan ($5,000,000 x .01 = $50,000).
In practice, loans generally do not have a fixed penalty percentage but rather a sliding scale based on the loan’s age. The agencies will describe this scale using shorthand notation such as “5-4-3-2-1” or “5-5-4-4-3-3-2-2-1-1”. That first example means “pay 5% in the first year, 4% in the second year, 3% in the third year, etc., etc.” The second example is for a 10-year loan and you only get to a 1% penalty in the 9th year.
The yield maintenance penalty is a little more complicated to understand. The goal of this penalty is to allow the lender to earn the same return as if they had continued earning the interest on the loan through its original maturity date. For example, if you took out a mortgage with a 10-year term and decided to pay it off in the eighth year, the lender will lose two years’ of interest payments.
To calculate the yield maintenance payment we need three pieces of information: the amount of time remaining in the loan’s term, the loan’s current balance and the replacement rate. The first two parameters are straightforward and are simply attributes of our mortgage. The last parameter, the replacement rate, is the difference between the loan’s interest rate (which is a fixed value set when the loan was originated) and the yield on a U.S. Treasury bond with a maturity equal to the loan’s remaining term…and this is where things can get complicated.
As you may be aware, Treasury bonds are issued in a standard set of fixed maturities including 1-, 2-, 3-, 5-, 7- and 10-years. If, as in the example above, you are prepaying your mortgage with exactly 2 years remaining in its term then you could open your copy of the Wall Street Journal, find the Treasury rates table, and then read the yield for a 2-year bond. But what happens if your loan actually has 1 year and 11 months left, instead of two years? In that scenario you (actually, the loan servicer) will need to determine the appropriate Treasury yield by interpolation. This means they will create a chart with the 1-year yield and the 2-year yield, and then draw a line connecting these two points. Where this line crosses the point for 1 year and 11 months is known as the interpolated Treasury rate.
Now that we have the Treasury rate we can calculate the replacement rate, which is: Loan Rate – Treasury Rate. You will notice in this formula, that if the two rates are equal the replacement rate will be zero…which means you will have no yield maintenance payment! (Note that in reality the agencies set a floor on this payment; no matter what the replacement rate is the minimum penalty due is always 1% of the loan balance.)
How Do We Choose?
Many times when acquiring an investment property we have a certain business plan in mind and we plan to sell that property within a certain time period. For example, we’re buying a multifamily property where we think a value-add program will increase rents and within three years the property will be worth a lot more than when we bought it. However, even though we think we will be ready to sell the property in three years we decide to take out a five year mortgage – just in case we’re not ready to sell in three years, the longer-term mortgage will provide some breathing room to execute the business plan.
Mortgages with the Yield Maintenance option have a lower interest rate than those without. Does that mean you should always choose this option?
In this example, we could get a mortgage with a “5-4-3-2-1” prepayment schedule. If we do, we will know exactly how much of a prepayment penalty is due no matter when we repay the loan. A few years ago I would have advised most of my clients to choose this option. But today, maybe not.
In the last few weeks and months the business press has been breathlessly reporting the Fed’s determination to start increasing interest rates. It looks like we have now decisively entered a period where interest rates will be rising for the foreseeable future. Therefore, in the above loan example, it is highly likely (though not guaranteed) that three years from now when it comes time to pay off this mortgage Treasury rates will be notably higher than they are now. In fact, it may even be possible that Treasury yields will have risen to the same rate as the interest rate on this mortgage. Or, put another way, it’s possible that the yield maintenance penalty will have fallen to zero!
For the particular loan you may be considering right now there will be a breakeven point where it is cheaper to choose the Yield Maintenance penalty option instead of a percentage fee. You can find various calculators online to help with figuring out the math for your particular loan scenario.
We are now entering a period where interest rates will be behaving in ways we have not experienced in many years. The assumptions of the last few years will have to change. Talk to your mortgage advisor and make sure you understand the options available to you – and what those options mean in today’s new interest rate environment.
Originally published at Rental Housing Journal on March 20, 2017.