(Update: Periodically we'll be going back into the content vault here at PrecisionLender and resurfacing some of our most popular pieces. This article by Joel Rosenberg, which originally ran back in 2015, certainly fits the bill. We've touched it up a bit and brought it back out to the front page of the blog to give more of readers access to it.)
Most commercial loans have a stated term. While there are some “Demand Loans,” where the bank can demand payment at any time, borrowers generally prefer the certainty of knowing when their loan is due. However, borrowers may want to repay some or all of the remaining balance of a loan prior to maturity.
The reasons for the prepayment can vary: Perhaps the client is having a very profitable year and want to use the extra funds to pay down the loan, or maybe they've sold the collateral supporting the loan. And of course it could simply be that they have the ability to obtain a new loan with a lower interest rate.
If a borrower wants to make a partial or full prepayment of a commercial loan prior to maturity there are three states that they face …
1. No prepayments are permitted, either partially or in full prior to some date.
This usually occurs for larger loans that are syndicated or securitized. In some cases, there can be no prepayments at all during the life of the loan. However, in most cases there is some limit, like the first two or three years.
2. The loan can be prepaid and there are no consequences to the borrower.
In other words, there is no prepayment penalty or fee access for payments prior to maturity. In some cases, the loan documents may state a penalty, but it is either waived or under certain circumstance - such as the sale of the underlying collateral - it is not accessed. This is the state that generally occurs; many banks will waive any penalty fee if there is a new loan and it originates from the bank that made the original loan. Also, most banks will not charge a penalty if the prepayment is less than 10% of the original principal.
3. The loan can be prepaid, but there is a penalty.
This penalty is often charged if the loan is being fully prepaid prior to maturity.
Prepayment Penalty Methods
There are several formula and methods used for the prepayment penalty fee. They range from very modest penalties to those that fully protect that bank. Some examples are:
A set fee, like $1,000
This is assessed no matter what the remaining size or term of the loan. In most cases, this is minor and primarily reimburses the bank for its expenses to release collateral on the loan and terminate the borrower’s obligation.
A set percentage, like 1% of the loan amount
Depending on the size of the loan, this can be more meaningful, although this rarely compensates the bank for the loss of interest if a higher rate loan is replaced during a period of lower interest rates.
Some percentage formula that varies with time
Examples include 5-4-3-2-1 or 3-3-3-2-2-1. In the first example 5% of the remaining balance is the penalty if the loan is prepaid during the first year of its life, 4% in the second year, 3% in the third year, etc. This recognizes that the longer the remaining term of the loan, the more value it likely has to the bank; thus a higher compensation is needed. This partially compensates for interest rate risk, but in most situation it rarely fully meets the bank’s loss.
Yield maintenance (sometime called "make whole")
This is intended to fully compensate a bank for any lost interest between what the present rate is on the loan and new rate, given the current environment for the remaining term on the loan. Since, for most fixed rate loans, the beginning rate stays the same over the life of the loan, for those with longer terms there can be significant movements in the economic environment that result in lower interest rates. Also, even if the interest rate environment does not change, given the shape of an upward sloping yield curve, rates for the remaining term will fall due to the term structure of interest rates.
The issue with yield maintenance is that it is difficult to explain and complex to calculate. If there is a sharp drop in interest rates, this can result in a high penalty (see table below). The steps to calculate it for a monthly amortizing fixed rate loan are as follows:
- Determine the monthly balance of the loan from the present until maturity. The standard loan payment calculations can be used (as shown in the example below). If this is a fully amortizing loan, by the time of final term the amount outstanding will be zero. For a balloon type loan there will be some remaining principal.
- On a monthly basis take the calculated amount from item one and multiply it by the monthly difference between the original rate and the new rate for a loan of similar remaining term. Say the original rate was 6% on a five year loan. After two years, when the loan is to be repaid, the new rate is 4%. This is a difference of 2% annualized (assuming an actual/365 or actual/actual interest accrual method) or .1666667% monthly.
- Present value these monthly amounts based on a rate as stated in the loan prepayment language. In some cases the present value rate is simply the new loan rate (4% in the example above). In other cases it is the “risk-free rate”, usually the treasury yield curve or the treasury rate for the stated new term. In a few cases, it is the Libor/swap curve.
- Sum up these present values. This is the penalty.
An example is shown below for a fully amortizing loan that originally has a 6% fixed rate for five years. This loan is prepaid after two years and the new rate for a three-year loan is 4%. This example assumes that the remaining loan amount is slightly over $1 million.
The expected balance at the original 6% rate is shown in column B, in column C is the lost interest (column B times .166667%) and Column D is the present value of each of these payments based on the treasury yield curve as of June 19, 2015. The present value calculation is PV = Balance of the loan/ (1 +treasury rate for that term/12) ^ (time remaining until maturity for that balance in months). Column E uses the new loan rate 4% per annum for the discount factor. The sum of the present value factors or the penalty is shown at the top of the table below.
A second example shows this same situation but here we have a balloon loan with a 20-year amortization and a 5-year original maturity.
This final table shows the penalty required using the balloon loan from the previous example, but - varying the original rate and the new rate - the discount factor is assumed to be the new interest rate for the remaining term of the loan.
This same formula can be applied to a variable rate loan, but the difference in the rate is generally viewed as the difference in the spreads. If the original loan had a rate basis of prime plus one percent and the new loan had a rate basis of prime plus one-half percent, the difference applied to the balances is one-half percent. The discount factor is usually the new current rate (3.75% in this example, based on prime back in late June 2015). If the original loan is at prime plus one but the new loan is at one month Libor plus 300 basis points, the difference is simply what the current rate would be at present and at the new index and spread.
In some cases in which the new rate is above the current rate, the calculation results in a negative penalty, or the bank owing the borrower. This situation is usually negated by a provision that the penalty cannot be negative or in some cases less than 1% of the remaining balance.
Yield maintenance is the best method to compensate a financial institution for the lost interest and their interest rate risk in the early paydown of a loan. It is generally not used for smaller loans, but is often employed for loans that involve an interest rate swap or matched borrowing from the Federal Home Loan Bank. In both of these latter situations, the bank is merely transferring the penalty received to a third party to pay off the liabilities supporting the original loan.