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Definition of "Pre-payment Penalty"

Representing loans to CMBS (commercial mortgage backed securities) lenders and Life Insurance Companies will probably result in their quoting a "prepayment penalty" for a portion of the loan term. Simply stated, a prepayment penalty is the lender’s method of controlling their loan payoffs or recovering yield loss through a compensation from the borrower paying the loan off early.

For many years, the life insurance industry has typically quoted a prepayment penalty using a "YIELD MAINTENANCE" method of calculation. With the proliferation of CMBS lenders, during the 90’s decade, a new and perhaps easier method to address (explain to the borrower) has surfaced, IE: "DEFEASANCE."

This is our attempt to explain each of these methods to assist you in evaluating the potential penalty on your loans.

This calculation protects the lender against a decline in interest rates. During a declining interest rate period, borrowers would typically try to refinance their loans in order to improve their loan’s interest rate, therefore paying off existing loans.

Based on the original loan, term and rate, a lender expects certain cash flows. If the loan pays off early, in a lower interest rate period than when the loan was originally cast, the lender would lose this cash flow by being forced to reinvest the proceeds of the loan paid off in a lower yielding investment (loan). The lender needs a shield against this loss of yield and requires the borrower to compensate for the early payoff. This compensation is called yield maintenance.

Yield Maintenance amount is established by calculating the net present value of the remaining interest due on the loan to the end of the "Prepayment Period." The loan payoff discount rate would be the difference between the existing T-bill rate (or index used for the rate calculation at the time the loan was made) and the original mortgage’s interest rate. This difference is the penalty for prepayment.

Defeasance is the substitution of the current collateral with United States Treasury Strips that exactly mimic the stream of payments promised at the origination of a loan. If treasury rates rise above the original mortgage rate, the borrower benefits because the price of treasuries will fall and the borrower will be able to set up a portfolio that mimics the original cash flows at a lower price than the amount that would have had to be repaid.