COMMERCIAL MORTGAGE 101
Lender Prepayment Premiums Part 1
Why would a borrower be assessed prepayment premiums when repaying a mortgage contract early?
Depending on market conditions and a borrower’s priorities surrounding debt obligations, one may determine to repay a mortgage contract prior to the actual maturity date. This creates a situation in which the lender, without certain contract provisions, would not have the opportunity to earn the interest that was anticipated when the financing was originally negotiated. This potential has established an environment in which lenders have created the necessary provisions to ensure that they are “made whole” and do not miss-out on the profits (interest) from a mortgage contract.
Prepayment provisions in a loan document vary significantly from lender to lender and loan to loan. Some of these provisions are relatively simple and can be outlined with a brief explanation while others have become very complex and have resulted in the creation of enterprises devoted solely to assisting in the understanding and execution of complex loan prepayment.
Brief descriptions of the most frequently utilized prepayment provisions are highlighted below:
Minimum Interest Payment: Simply, the borrower is responsible for a minimum, aggregate dollar-amount of interest payment over the term of the loan regardless of when the loan is repaid in full.
Declining Balance: The “traditional” prepayment structure; the borrower is assessed a penalty equal to a percentage of the then-outstanding loan amount. The prepayment premium percentage declines over the term of the loan at defined intervals, typically annually on the anniversary of the loan closing.
Yield Maintenance: A prepayment structure that allows the lender to attain the same yield or rate of return by theoretically investing the prepaid principal instead of having the borrower make all scheduled interest payments until loan maturity.
Defeasance: A provision that, essentially, voids a loan. The borrower, instead of paying cash to a lender upon prepayment, exchanges another cash-flowing asset for the original collateral for the loan. The new collateral (normally treasury securities) is usually less risky than the original asset and provides potential financial gains to both the lender and borrower.