Let's Talk Dirty: Prepayment Penalties
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“Prepayment Penalty” tends to be a dirty word or phrase in the circles in which I associate. People don’t want to be punished for paying a loan off early; I get that. As a financier with nearly two decades of experience, let’s talk about why a Prepayment Penalty (PPP) actually makes sense for investment real estate, why it is not dirty, and why I have them on my own DSCR loans.
Investors Only
First of all, PPPs are not permitted on consumer purpose (primary or secondary home) properties.
Similar to exemptions with the Securities and Exchange Commission for equities trading, there is a certain level of risk acceptance and sophistication that is expected with real estate investors as opposed to consumer-purpose occupants. If you’re going to be a real estate investor, you’re expected to have educated yourself enough to understand these things. And here you are, doing exactly that. Good job!
What the PPP Actually Means
When I started my first mortgage brokerage in 2021, the industry standard was a 5 year declining, or 5 years at 6 months. The industry standard does change according to the economic environment as national and global factors impact risk, and industry trends impact competitiveness in pricing. Each lender will set their own definitions around these, so please evaluate your actual note to determine what yours means. Generally accepted definitions are:
5 Year Flat, or 5 Year 5%: If greater than 20% of the outstanding principal balance is paid off early within a rolling 12 month period, 5% of that amount will be due as a prepayment penalty. In layman’s terms, if the outstanding principal balance is $100,000, and $15,000 is paid down in November, and an additional $10,000 is paid down the following February, this equals $25,000 in principal pay down. This is 25% of the outstanding principal balance, so greater than 20%, in two separate calendar years but within a rolling 12 months. Therefore, the PPP is 5% of $25,000, or a whopping $1,250.
Okay, those are relatively small numbers. Let’s say you pay off $350,000 early, as is about to occur on one of my properties. The PPP on that will be $17,500. Clearly, a decision has been made that makes it worth it.5 Year Declining or Stepdown or 5/4/3/2/1: If greater than 20% of the outstanding principal balance is paid off within the first 12 months, 5% of that amount will be due as a prepayment penalty. In months 13 through 24, the PPP is 4%. In months 25 through 36, the PPP is 3%, and so on. There are many variations to this one. I have seen a 5/4/3/3/3 combination and a 5/5/4/4/3 combination. Like you and your investment real estate, lenders can get pretty creative.
5 Years at 6 Months: If greater than 20% of the outstanding principal balance is paid off early within a rolling 12 month period, 6 months of interest that would have been paid will be due as a prepayment penalty. Let’s assume an interest only loan to make this simple. In layman’s terms, if the outstanding principal balance is $100,000 at 12% interest only, the interest payment is $1,000 per month. If $20,000 is paid down, this equals 20% of the principal balance, and the PPP is 6 months of interest that would have been paid on that sum, or $600. If the entire loan is paid off, the PPP would be six months of interest on the full balance, or $6,000. This one is far less common, but I do see it from time to time.
Why do PPPs Exist?
To answer this question, let’s begin with another one. Where does the money that you borrow come from?
It comes from people just like you. Yes, a lot of it comes from institutional investors, i.e. companies. But who ultimately owns those companies? People just like you. They are individuals who are investing to accumulate and preserve wealth, just like you.
Risk Premium
Those who invest in DSCR loans have a higher risk tolerance than those who invest in conventional loans, and in exchange for taking on that higher risk they receive a higher yield. So that we’re clear, when you get a government-backed loan like FHA, you are not borrowing money from the government; you are borrowing money from investors to whom the government has guaranteed repayment. These are government insured loans. (When you pay PMI, it is the premium for this insurance.)
Asset Type: Investment real estate is higher risk to the lender than owner-occupied because housing providers will pay their primary mortgage payment before they pay their investment mortgage payment if things get sideways.
Lean Underwriting: DSCR underwriting relies on less personal borrower documentation, basing decisions primarily on asset cash flow rather than full global financials.
Liquidation: The greater number of units on one property, the higher the risk because a single family home is much easier to sell and get the lender’s money back on than a duplex or a triplex. The pool of potential buyers for a multiunit property is simply smaller than for a single family property.
Greater risk is offset by higher repayment terms.
Minimum Return
When you purchase or otherwise invest in a real property, you do so because you have evaluated the likely rate of return and determined that it will meet your goals. Similarly, in order to entice capital for your deal, a minimum return is expected. They consider 6.5% for 10 years more advantageous than 6.5% for 1 year and then the funds have to be placed again at who-knows-what interest rate. Sourcing, evaluating, and executing lending opportunities carries real transactional costs. Therefore, if a borrower takes a 30 year loan at 6.5% and repays it in 3 years, the lender’s long-term yield has been negatively impacted. To protect that yield – and to secure you a 6.5% rate instead of a 10% rate pricing premium—the PPP is established.
You absolutely could buy that PPP down to 1 year (which is generally the minimum) if you wanted to, but it’s going to cost you either discount points, or a much higher interest rate, or both. Otherwise, no one will want to buy the note, which means you don’t get to borrow the money at all.
You expect a minimum return in order to transact business. So do lenders.
State by State
Allowable PPPs do vary depending entirely on the state where the subject property lies (your location or the originator's location doesn't matter).
As previously stated, the current DSCR industry standard is a 5 year 5% flat PPP. When you ask for best pricing on a DSCR loan, that includes the current industry standard PPP.
In states that have lesser allowable PPPs, you, the borrower, are forced to buy down the PPP from the industry standard. For example, whenever I price a DSCR loan in Ohio, that loan will always be more expensive on a one or two unit residential property than if it was in Tennessee, where I live. Every single time, every single loan, this is a fact. This is because the officials in Ohio have seen fit to disallow a PPP longer than 3 years or greater than 1% on single family or two-unit investment properties. So you, the borrower, are forced to buy that down, making your pricing higher. (And making it more difficult to qualify for your loan in the first place, because this directly impacts the debt service coverage ratio of the property.)
Why I Nearly Always Recommend Keeping the PPP
Remember that level of sophistication that is expected of you as a real estate investor? When you enter into a 30 year note, it is expected that you have assessed the overall costs of doing so and determined that a long-term hold of this property is worth it for at least 5 years. If macroeconomic factors shift and you decide to change your mind early via a sale or a refinance, you are going to incur transactional expenses regardless—title fees, escrow costs, closing points, or seller concessions. Think of the PPP simply as one of those cost-of-doing-business exit expenses.
You will have expenses to refinance or sell the property. The PPP is one of them.
If you buy down the PPP when you acquire the loan, you are incurring a higher interest rate, higher loan costs, or both, for an event that might happen: selling or refinancing the subject property within the time frame indicated. If such an event does not happen, you’ve paid in advance for nothing. So essentially, you will have paid the prepayment penalty in advance for no reason whatsoever. And you’re not a silly goose, so you’re not going to do that!
You’re Okay, I’m Okay, We’re All Okay
As the sophisticated real estate investor that you are, who has thoroughly performed the appropriate due diligence, you have made a decision to finance a property at a particular interest rate for a set period of time. To induce someone to agree to lend that money to you, they also have made a decision that there is a particular yield they want to receive. This yield reflects the risks they have assessed in the transaction. To give them peace of mind that their risk assessment is sound, and to optimize your cashflow and overall cost of funds, you promise that you will make your payments faithfully for a minimum period of time. This is beneficial for both parties.
Prepayment penalties have a bad reputation, but they bring you, the borrower, a ton of relief from much higher interest rates. You silly goose.
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The content provided is presented for information purposes only. This is not a commitment to lend or extend credit. Information and/or dates are subject to change without notice. All loans are subject to credit approval. Other restrictions may apply. Kristin Fleming | NMLS #804170 | Barrett Financial Group, L.L.C. | NMLS #181106 | 2701 East Insight Way, Suite 150, Chandler, AZ 85286 | TN 204577 | Equal Housing Opportunity | Equal Housing Lender | nmlsconsumeraccess.org/EntityDetails.aspx/COMPANY/181106
