There are several types of prepayment penalties: Sliding scale; Guaranteed interest; Yield maintenance; Defeasance; Lockout
A sliding scale prepayment penalty schedule, also called the graduated prepayment or, more appropriately, the declining percentage prepayment, is easiest to understand: the borrower is required to pay the lender a certain percentage of the amount being prepaid as a penalty. A prepayment penalty of 5-4-3-2-J, for example, means that the borrower must pay an additional 5% of the amount prepaid if the he or she wants to make any principal payments ahead of schedule during the first year. Similarly, if the borrower wants to make an extra principal payment during the second year, he or she needs to pay an additional 4% of the amount prepaid as a prepayment penalty. And so on.
The main advantage of the sliding scale prepayment penalty structure is that the penalties are simplistic, easy for most people to understand and, unlike some of the prepayment penalty schemes we will describe later, can be calculated with a minimum of arithmetic. The disadvantage of it is that that it makes no sense!
Does something magically happen to the real estate market on the first, second or third anniversary of the loan closing, that should make the prepayment penalty drop by a whole point?
Does it make sense to charge the same penalty regardless of what the prevailing rates on a new mortgage would have been?
The answer to all these questions is "no." So while the sliding scale prepayment penalty scheme is the most common and the most simplistic, it also the most arbitrary and lease sophisticated.
Guaranteed interest is seen frequently seen in interest only loans, such as bridge, hard money, and contraction loans. Under this scheme, the borrower is obligated to pay the interest for all or part of the loan term, regardless of whether or not the mortgage is paid off early. For example, a $1 million one year interest only mortgage with a rate of 12% might have guaranteed interest prepayment penalty of six months. That means that the borrower guarantees the lender at least $60,000 in payments (corresponding to 6 months x $10,000 per month). If the loan is kept for the full six months, then the $60,000 will been paid out monthly--$10,000 per month. If the loan is paid off before the six months, the borrower will have to pay $60,000 at payoff, minus any interest payments made to date.
A guaranteed interest prepayment penalty, combined with an interest reserve is fantastic racket. Think about the loan scenario we just entertained: you take out a loan according to the following terms and conditions:
Loan amount: $1 million loan Interest rate: 12% Amortization: Interest only Monthly payment: $10,000 (1% x $1 million) Interest reserve: six month interest reserve ($60,000) Prepayment penalty: guaranteed interest for 6 months (again, $60,000).What happens next is this: $60,000 gets taken out of your $1 million loan--you only get $940,000 at the closing table. The rest gets placed into a real or fictitious account, controlled by the lender, from which monthly mortgage payments are made to the lender.
The lender keeps the sixty grand no matter what happens. If you keep the loan for at least six months, that money it gets paid out--from the lender's right pocket to the lender's left pocket--as interest. If, on the other hand, you pay the loan off early, the lender keeps the money as a prepayment penalty.
Either way, you'll never see the money--ever.
Yield maintenance is similar to the guaranteed interest prepayment penalty we just discussed in the sense that both forms of prepayment penalties require the borrower to compensate the lender for a loss of a future expectation of interest payment--or yield. However, yield maintenance is a little bit more sophisticated than that because guaranteed interest obliges the borrower to pay a fixed interest, while the yield maintenance penalty requires the borrow to pay a penalty that is proportionate to the yield, at the time of prepayment, of a specific security, frequently U.S. Treasuries. This prepayment penalty makes a lot of sense. After all, the lender's real loss is the yield which the borrower promised the lender; it is the yield which the borrower promised the lender, minus the yield that can be gotten by reinvesting the money in a readily-available and secure investment.
Let's use an example. Suppose borrowed $1 million exactly five years ago. The loan was for a 10-year term, a 30-amortization, a rate of 6%, and had a yield maintenance prepayment penalty. Your balance is $935,195.
If you prepay now, the lender loses because, presumably, the lender will have no place to invest your money, except in widely available and ultra-safe securities that mature in exact five years--in other words, 5-year Treasury bills. The problem with this investment from a lender's point of view, however, is that 5-year Treasuries are paying 4.5% per year (let's say), while the rate on your mortgage was 6%. So the lender is losing 1.5% (6%-4.5%) on amount prepaid for the next five years.
And since the lender doesn't want to get stuck with that bill, you will. The lender will assess a yield maintenance prepayment penalty--literally, a penalty that requires you to maintain the promised yield--that's equal to the principal being prepaid multiplied by the present value of the difference between the remaining yield (interest rate) on the mortgage and the yield of a Treasury security, whose maturity date is comparable to the maturity of--or time left on--the mortgage you are trying to prepay.
Notice that the lender suffers no actual loss at the moment of prepayment. All the loss occurs during the coming five years, and the yield maintenance formulas are designed to calculate what those future loses are worth today. This isn't something that you can compute with you fingers--or your toes. You'll need some nifty software or calculator to figure out the present value of five years worth of yield loss.
But even without cranking out your rusty abacus, you can spot some general trends here such as: if the comparable Treasuries have the same yield as the rate on the existing mortgage there is no net loss of yield to the lender. The lender can take the mortgage money and buy Treasuries without losing any yield. Similarly, if the comparable Treasuries are much higher than the rate on the mortgage, the lender will profit if the borrower prepays. In that case, the lender will be able to--worst case scenario--reinvest the money in comparable Treasuries--at a profit. And finally, if Treasury rates drop significantly during the term of the loan, the prepayment penalty will have to go up to compensate the lender for the loss of yield.
Now, I said that if comparable Treasuries have the same yield as the rate on the existing mortgage there is no net loss of yield to the lender. Does that mean that in such a situation the lender experiences no net loss or gain of any kind? No it does not, for two reasons:
Treasuries are a much safer, easier to manage investments. If the loan pool is large enough, this lack of risk is quantifiable and can easily be converted into dollars. Therefore, once the loss of yield is fully compensated for, the lender walks away with the added financial benefit of having reduced the risk to its investment..
Paying off a loan early disrupts the lender's profit model by preventing them from recovering processing expenses and by crimping the potential income stream that would have come from servicing and a variety of other sources. To compensate for this, lenders assess a minimum penalty of 1% of the amount being prepaid, even when there is no net loss of yield.
So in sum, the yield maintenance prepayment penalty is calculated as the greater of: 1% of the principal being prepaid; or the principal being prepaid multiplied by the present value of the difference between the remaining yield on the mortgage and the yield of a comparable Treasury security.
Defeasance: Yield maintenance has one important weakness. Under yield maintenance, the lender received a cash compensation at the time of prepayment, when, in fact, the lender might not want one. The lender might prefer that the mortgage remain, together with a pool of other mortgages, so that people bought bonds secured by that mortgage will be able to get the same income.
So in comes defeasance, which is yield maintenance on steroids. Defeasance actually requires the borrower to purchase a collection of securities that produces an income stream that exactly matches the real estate mortgage payments. These securities are then placed in a special trust. The mortgage is then transferred from the real estate and placed onto the Treasuries, or other securities, instead.
So, a defeased loan is never actually prepaid. The loan survives; only the collateral changes. It follows, then, that defeasance isn't a prepayment penalty--the loan is not being paid back. Nonetheless, defeasance still costs a ton of money. The borrower has to pay a lot of fancy, high-class educated people to buy my upcoming book, to do the defeasance calculations, to set up and administer the trust, to substitute the real estate collateral with securities, and, eventually, to send all the lawyers' kids to college.
What defeasance accomplishes
Securitized mortgages are, by definition, sold off as bonds. These bonds are not callable. Meaning, if interest rates drop in the middle of the loan term, the mortgagor can't just refinance at a lower rate and screw the bondholder out of a his fat double-digit yield. No. The borrower promised "X" percent, so the borrower will pay "X" percent. The mortgage will not go away. The borrower can sell the property and have the loan assumed by the new owner; the borrower can do flying camels and triple Lutze's all day. Doesn't matter. Either way, the loan will survive and continue paying the bondholder whatever he or she was promised.
If you were a CMBS investor, is it better for you to have defeased or not?
The answer is yes! Remember, government securities are the safest form of investment, and if your loan is defeased your collateral becomes an ultra-secure government bonds.
Lockout is a period of time during which a loan cannot be prepaid at all. The lender will send your money back to you if you try to prepay. Some people use the term lockout when they really mean guaranteed interest, which we discussed earlier. This confusion is annoying because it's totally unnecessary. So a true lockout prepayment penalty is not assessed in dollars, it's just a bar, a ban or prohibition against prepayment.
MarCapital
Commercial Mortgage
Advisory Service
(212) 931-8551
MARK YOFFE, PRESIDENT, MARCAPITAL, INC.
COPYRIGHT 2005 Hagedorn Publication
COPYRIGHT 2005 Gale Group
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