In our experience working with both lenders and borrowers on commercial loan matters, we often find that borrowers overlook or fail to properly address the prepayment penalty prior to closing. Prepayment penalties are almost always included with commercial term loans and can be a costly additional expense when refinancing or paying off the loan. Lenders are rarely able to eliminate the prepayment penalty entirely, but there are almost always ways to qualify or mitigate the penalty’s effect when and if you know how to approach the issue.
Prepayment penalties typically apply in one of three ways. The most common it what is referred to as Decreasing Percentages, where the penalty starts at 5% or 3% of the amount prepaid and decreases incrementally each year until it either terminates or remains at a stated percentage for the remainder of the term. Another common prepayment penalty is what we refer to as Yield Maintenance, which can be summarized as an amount equal to the interest the lender is missing out on because of the prepayment. A third example we routinely see is a flat percentage for part or all of the loan term.
When we’re engaged by our clients to review and negotiate loan documents on their behalf, the prepayment penalty is always one of the things we will point out and walk through with them. There are a number of ways we can approach this concept, and I highlight two of most common ways below.
One way we mitigate prepayment penalties is to limit them only to prepayments resulting from refinancing the loan with another lender. This allows the borrower to freely make prepayments of principal from operational cash flow. Some borrowers may assume that this is allowed without it being expressly included, but that is not always the case. Lenders often are willing to allow for this when asked so it’s an obvious staring point when addressing it with them. If the lender is not willing to allow for unlimited prepayments from cashflow, we are usually able to negotiate an annual limit as a compromise for all parties.
Another important concept when negotiating prepayment penalties is to create a no-penalty window leading up to the scheduled maturity date. Almost all commercial term loans are designed to balloon, meaning the maturity date comes before the loan would be paid off based on the amortization schedule. This means the borrower will have to refinance the loan and if the prepayment penalty applies through the maturity date, the borrower is inevitably going to have to pay it. No matter what type of prepayment penalty is in effect, we make sure that for the final 1, 3, maybe 6 months of the loan, the borrower has a no-penalty window to account for this eventuality.
Ultimately the best way to address a prepayment penalty and what a particular lender is or is not willing to compromise on depends on a variety of factors, such as the borrower’s creditworthiness, the borrower’s relationship with the bank, and the nature of the specific loan. If the concept was not discussed prior to closing, lenders may be willing to negotiate the penalty down leading up to a refinance or payoff, but this is an unnecessary risk. The best way is always to address this concept prior to closing so borrowers can set themselves up for a cost-effective transition at the end of the loan’s term.
Please contact me should you need a review of any of your contracts before a dispute like this arises.
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