“PrePayment Penalty“ is an unfortunately named term for a common – and important – practice in commercial mortgage lending.
The word “Penalty” seems negative to most borrowers, understandably. At best, it often comes across as a “necessary evil”. In actuality, it’s more of a “Subsidy” than anything else, in that it works to the borrower’s advantage.
Small cap commercial loans are typically high-risk propositions. Most lenders understand this far better than most borrowers, it seems. Most borrower’s focus on the “penalty”, or negative, aspect of this practice. Lender’s focus on the practical aspect, in that it’s a “win-win” way of resolving a dilemma they’re faced with in lending money on small commercial deals. (Without it, far more small commercial loans would be rejected than most borrowers realize.)
On the one hand, lenders are in the business of lending money, and they only make money when they loan money – obviously. On the other hand, what’s not so obvious is that if they do lend money with the interest rate and loan terms their underwriting and financial analysis of the deal would require in order to cover the deal’s inherent riskiness – especially in the challenging, rapidly changing financial environment we’re in today – most borrower’s wouldn’t be willing to accept the high interest rate called for – nor would the deal likely “cash-flow” or “debt service” with the higher interest rate and the resulting higher mortgage payments. So, what to do?!
The “win-win” solution is to offer to lend money with a lower interest rate, as long as the lender can be assured of receiving the loan payments based on that lower interest rate for a minimum period of time – one that assures them of the minimum return their underwriting and financial analysis of the deal require to make the loan.
So, if the borrower does not agree to make (lower) payments for a minimum length of time, then the lender can not justify making the loan, and the loan is turned down. If the borrower does agree, then the lender can approve the loan.
However, if after the closing, the borrower does not do as agreed (ie, sells or refinances before the end of the agreed upon length of time), then the lender is entitled – by the agreement – to a fee in the amount of the interest that the lender would otherwise have received, had the payments been made for the length of time agreed to.
Bottom-line: This “agreement” to make a lower mortgage payment for a minimum length of time in exchange for loan approval (at a lower interest rate than would otherwise be required) between the borrower and the lender, actually makes inherently risky small commercial loans “do-able”, in the final analysis. In this light, the lender, along with the agreeable borrower, effectively “subsidizes” the loan, thereby making it “do-able”. A “Win-Win” solution.