Prepayment Penalties in Commercial Real Estate

With each day that goes by, the CRE industry expands. More and more investors are coming in with capital that may be utilized to build out commercial properties that can accommodate the demands of enterprises. However, investors may not always have access to funds. 

Taking out loans in these situations is quite beneficial to them. Loans for commercial real estate have an interest that must be promptly paid. There will be a prepayment penalty, which is a cost if the borrower tries to pay off the loan early and wants to settle the obligation in advance. 

The lender will aim to make the most money possible within a specific time frame after issuing the loan. As restitution, there is a prepayment penalty. It aids in reducing the losses they would incur if the loan were repaid early. Understanding the prepayment penalty is essential for commercial real estate loans, which is why we will be going in-depth to explain the term and other important information concerning prepayment penalty you should know. 

What are Prepayment Penalties?

Several lenders levy a fee known as a prepayment penalty if you repay all or a portion of your mortgage ahead of schedule. If there is a prepayment penalty, you would have consented to it because it is included in the loan paperwork and is permitted for some loans, such as personal loans, investment property loans, and conventional mortgages. 

If you repay a significant portion of your mortgage in one go, there may, in some situations, be a prepayment penalty. Prepayment penalties usually only apply when the total mortgage sum is paid off. Because, for instance, you sell your commercial property or are refinancing your mortgage within a given timeframe, typically three or five years 

Although it’s usually a bright idea to double-check with the lender, prepayment penalties often do not apply if you pay extra principal on your mortgage in small amounts. 

How do Prepayment Penalties Work?

A prepayment penalty may increase refinancing costs within the first few years of obtaining a commercial real estate loan. Only a handful of people have the financial means to repay debts within the first year or two of obtaining them. But many individuals will renew their loans if the interest rate drops or their credit score rises. 

Prepayment penalties differ depending on the lender and the kind of mortgage. All lenders don’t always charge them, or they may have restrictions. Prepayment penalties are only applied for the initial few years of a loan; after that, they gradually disappear, often after three to five years. 

When are Prepayment Penalties Likely to be Used?

Since interest is the primary way lenders generate revenue, paying off a mortgage early results in a loss of tens of thousands of dollars—if not more—in interest over the course of the loan. Lenders have more significant financial risk at the beginning of the loan period because they haven’t yet had an opportunity to collect substantial payments for the loan to be lucrative. When a borrower is viewed as a risk by the lender, putting a prepayment penalty on a mortgage can prevent early refinancing or a property sale during the first three years after closing. Alternately, when a mortgage is offered with a lower-than-average interest rate, prepayment penalties could be included as a strategy to recuperate some revenue. 

What are the Pros and Cons of Having a Prepayment Penalty on the Term Sheet?

There are majorly cons for the borrower because you cannot decide to pay back earlier if you get bulk money and want to clear your debt or get a better loan offer. If you do, there are additional charges incurred. 

On the other hand, the prepayment penalty is beneficial to the lender. You can be guaranteed to make profits on your commercial properties if you include prepayment penalties in your clause. Borrowers cannot just resale or refinance the property for a specified period and would have to pay the agreed amount over the specified timeframe.  

Why Would a Borrower Agree to a Prepayment Penalty?

Most of the time, you can cut the interest rate on your loan or mortgage by agreeing to a prepay penalty clause, which is the main reason borrowers agree to it. In some circumstances, a loan or mortgage will not be accepted for you, except if a prepayment penalty is included.

What are the Consequences of Violating a Prepayment Penalty Agreement?

Depending on the lender and the agreement, there can be different repercussions for violating a prepayment penalty clause. Knowing the ins and outs of the commercial mortgage conditions, including the prepayment penalty provision, is essential because the law demands that the lender give you a copy of them before signing day. 

If there is a prepayment penalty, you can also inquire with your lender as to which paperwork specifically mentions it. Typically, if you violate the prepayment penalty, the following can be ways you would be punished: 

  • A portion of the outstanding loan sum. 
  • A specific level of interest. For instance, due to your mortgage being paid off early, your lender can impose a 6 – 12 months sum of interest. 
  • A fee is modified depending on how many years are left on the commercial real estate loan. Most of the time, the interest rate begins at 2% of the initial loan and progressively declines to perhaps a half-percentage point for each succeeding year. 
  • A fixed price has been agreed upon in advance; this is less common than the other charges mentioned. 

How can Borrowers Protect Themselves from Prepayment Penalties?

There are some lenders to avoid if you wish to prevent prepayment penalties on your subsequent commercial mortgage loan. One of these is an alternate lender. They are usually non-bank, online lenders focusing on substandard mortgages and quick financing promises. 

You should also shun certain CRE loan products to avoid paying these fees. For instance, it’s recommended to steer clear of alternative lending products but stick with loans you may obtain wherever. Thus, if your lender attempts to add a prepayment penalty, you’ll be in a stronger position to negotiate their removal. 

Avoiding recurrent refinancing is another way to prevent prepayment penalties because it tells your lender that you’re more inclined to refinance as soon as rates drop. Additionally, you can look for a co-signer or make a larger down payment in return for a fairer loan term that doesn’t charge a prepayment penalty. 

Last but not least, you can wait out the time left before taking any actions to completely prevent the charge if your prepayment penalty term is about to expire. While some jurisdictions do not allow lenders to charge prepayment fees, it is always a wise option to complete your research in case your mortgage terms do. 

Final Thoughts

Repayment penalties can be harsh to borrowers, so if you wish to avoid them, you must be meticulous when searching for lenders and going through contract documents. To save you the stress of doing that by yourself, you can use Finance Lobby. 

Finance Lobby is an all-in-one solution for commercial real estate lenders and brokers looking to save time, increase their close rate, and find more perfect-fit deals. We’re transforming the CRE lending industry by making it easier for brokers and lenders to find deals they can close on.

October 27, 2022

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