When you get a loan from a bank or lender, they determine how much to lend and expect they’ll receive a certain amount of interest payments over the life of the loan. This is one way banks make money.
However, if you decide you refinance or sell the asset too soon, they lose out on those additional interest payments. Oftentimes, this can result with the borrower being hit with a prepayment penalty. This penalty will happen when the borrower refinances or sells the asset too soon in the loan term, generally between the first 5 years of the loan. The PPP can vary depending on the timing of when you refinance or sell the asset, but there are generally two types of penalties: Yield Maintenance and Step-down prepayment penalties.
The more “hard” of the two penalties, yield maintenance is a penalty the borrower pays, equivalent to the amount of remaining interest they would have paid over the life of the loan. Imagine a borrower took out a $1,000,000 loan at 4% for 10 years. This equates to $40,000 in interest payments yearly. If rates dropped to 3.25% and the borrower wants to take advantage, he may choose to refinance into new debt. However, when done, the lender will charge this hefty penalty to the borrower, allowing the lender to recoup any potential loss in interest payments they otherwise would have received. This type of PP makes it very unpopular for borrowers to refinance unless absolutely necessary.
Stepdown PPP (5-4-3-2-1)
Step Down penalties are structured like a staircase, so to speak. Say you have a 10 year loan on $1,000,000 of debt. Every year the loan passes, the prepayment penalty decreases. If you were to refinance or sell in the first year, you would pay a 5% penalty on the remaining balance, In the second year, 4%. Third year would be 3% and so on. Eventually, based on the agreement you have with the lender, the step down would burn off and you would be free to refinance or sell without penalty.
These concepts are important to know and understand when evaluating your debt terms on your next deal. If you are planning to do a value-add and refinancing in 3-5 years, it would not be beneficial to take out debt with a large prepayment penalty in those years. Speak with your broker or lender for the property debt for your deal.