When a loan is viewed as an investment, then a lender should be viewed as an investor. Like investors, transactions are evaluated on the potential returns of and on capital outlays. A lender underwrites the merits of a deal to measure risk and the viability of receiving interest payments, or profit, on their investment. This is no different than an investor’s analysis.
From a lender’s point of view, profitability is lost when a loan is satisfied before the term’s expiration. If a borrower saves interest, then the lender loses profit.
The Cost of a Prepayment Penalty
The cost of this penalty is a percentage of the outstanding loan balance. If a short-term loan is interest-only until the balloon payment becomes due, the rate is applied to the loan’s principal amount.
If a loan is over a longer term with a self-amortizing structure, then the prepayment penalty decreases as the principal is paid down.
The terms and the effect of this penalty can be found in the truth-in-lending disclosures, the loan commitment, and the loan documents.
It is the borrower’s responsibility to ensure that the terms of the loan documents mirror those of the commitment letter. A borrower should not sign a commitment or place a deposit until a complete understanding of all loan terms is in place.
A prepayment penalty ensures the lender’s receipt of its projected cash flow.
Knowledge is power, and below are three factors every borrower should consider when applying for a real estate loan with a prepayment penalty clause.
1. Less Flexibility
A borrower must realize that their flexibility will be limited when considering either a refinance or a sale of the property. Prepayment penalties are triggered by either event.
2. Cost of Capital
This penalty will increase the borrower’s cost of capital and will lower the profit margin.
3. Project Budget and Proforma
A borrower will only know the actual profit on an investment if a prepayment penalty is part of the projections. Be sure to understand the terms of this penalty and try to negotiate a “burn-off” or a phase-out of this requirement after a set period.
This strategy could prove beneficial when planning for any delays and unknowns that can surface in a rehab project or a sale.
Borrowers should know the types of loans that typically require a prepayment penalty. The common types are:
- fixed-rate real estate loans,
- commercial real estate loans, and
- subprime loans.
The Prepayment Penalty Checklist
Borrowers must evaluate all loan terms against a property’s proforma, budget, and projected profit. The prepayment penalty cannot be overlooked.
This penalty is an essential factor in a borrower’s exit strategy, and the proforma must illustrate the deal from the “big picture” view.
Below is a checklist of items a borrower should consider when calculating the effect of this penalty.
1. Rate Applied to the Penalty
If the quoted rate for the loan is lower than the projections, it may make sense to accept this penalty. The total cost of capital should be considered with the exit strategy. If the property can be held long enough to avoid or lower the penalty while maintaining positive cash flow, then the penalty becomes moot.
Hence, conservative budgeting and a proforma with conservative projections are important. Should the actual profits exceed the proforma, the prepayment penalty is easier to accept if it leads to a higher yield.
2. Holding Period
There is a point in a short-term, interest-only loan when the holding period renders the deal unprofitable. The break-even point in the holding period must be known. If a prepayment penalty can avoid continuous losses, then the penalty is easily accepted.
If you are an investor who values flexibility in the timing of a refinance or a sale, then the effects of this penalty need to be assessed. The terms of this penalty, or a lock-out period, will hinder flexibility for a strategic exit from the loan.
4. Financial Position
If a loan with a prepayment penalty is the only available program, the investor must consider the available cash to absorb the penalty or service the loan over an extended period.
As stated above, the ultimate profit may be worth the higher cost of capital.
Thus, a prepayment penalty should not be a deal breaker. The profit of an investment should outweigh the downsides of this penalty.
This article focuses on the importance of considering the penalty in the budget and the proforma. The total cost of capital must be planned and accounted for when evaluating the loan programs available for your next investment property.
If you are in the market for a hard money loan in Los Angeles for your next real estate opportunity and want to discuss the effects of a prepayment penalty, it is in your best interest to work with a reputable and experienced hard money lender in Los Angeles. PB Financial Group is a premier, direct hard-money and bridge lender that has provided quick funding since 2007 and closed over 2,700 loans. We aim to satisfy your financing needs efficiently.
PB Financial NMLS #357614/DRE #01522495