Deciding If a Yield Maintenance Prepayment Penalty Is the Right Option for You
If you’re new to the world of commercial real estate, the phrase yield maintenance prepayment penalty has likely never been part of your vocabulary before. If you are trying to acquire a loan for a multifamily property, however, you must be aware of your prepayment options so you can make correct financial decisions for the long run.
A yield maintenance prepayment penalty is extremely common in larger loan amounts and essentially guarantees that the lender will attain the same yield on the loan, even if the loan is paid off before the scheduled maturity date. Fannie Mae and Freddie Mac are two of the biggest lenders that offer yield maintenance and other graduated payment options. Qualifying isn't always easy, however, as it requires a very experienced borrower, with a strong financial statement and rigorous underwriting of the property. Borrowers that don't qualify for Fannie Mae or Freddie Mac financing can find CMBS or life company loans as great alternatives.
If the loan is paid off early, the yield maintenance prepayment penalty is then calculated to determine the amount of funds the lender is entitled to in order to satisfy the investment. According to Fannie Mae, if the principal balance of the loan is paid off between the effective date and yield maintenance period end date, the amount of the prepayment will be calculated as either: one percent of the amount of principal being prepaid; OR can be found by multiplying the present value of remaining loan payments by the difference between the loan interest rate and the Treasury rate that is of the same duration.
In an environment where interest rates are stagnant or falling, a yield maintenance prepayment penalty can be a more expensive alternative for a borrower as opposed to a step-down, or declining prepayment penalty that is typically offered by banks (this is the most flexible type of option as your penalty can gradually decline over time, but is geared more towards those who are seeking shorter term loans). For example, the standard yield maintenance prepayment penalty can be as steep as 3% of the original loan amount in certain situations, whereas a step-down prepayment penalty over the course of a 5-year loan can decline to 1% of the original loan amount.
The lender is also on the short end of the stick when interest rates are declining because they are not able to re-lend that money at the same rate of return after the loan is satisfied. In an environment where interest rates are rising, however, yield maintenance can actually be beneficial for both parties since the lender can now go back out into the marketplace and re-lend the money to a new investor at a higher rate– it’s a win-win for everyone.