One of the most important issues facing borrowers today is should they refinance their existing loans. Interest rates on new loans are near historic lows, no one wants to miss out on those low rates. However, with Commercial and Multifamily loans, the decision is somewhat complex because most of them have some sort of prepayment premium or penalty. Additionally, with short-term treasury rates at close to zero, yield maintenance and defeasance prepayment penalties are unusually high. Borrowers, even in the last year or two of their loans are seeing prepayment premiums of 5%-10% of the loan amounts.

Borrowers with prepayment penalties feel trapped in their loans. They think that they can’t prepay the loan until the prepayment period ends, and they are worried about how the world will look in a few years when they do have to refinance. These borrowers may be correct about not refinancing today, but the real frustration is they really don’t know how to analyze the refinance decisions. They are usually making emotional decisions because they feel it’s just not fair that lenders are charging so much to pay off their loans.

While paying a large prepayment premium does seem crazy and unfair it sometimes is the best approach. Not only will refinancing eliminate the worries about where rates will be in the future, it may be the best economic decision. Of course anyone evaluating any financing option must not consider the economic issues in a vacuum, but must consider them in light of his or her real estate strategy. Is the property one the borrower wants to hold on to for a long time or something he or she plan on selling soon? Does the property need a face lift or cash infusion for rehabilitation? Is the borrower focused on cash flow or long term value? Once, the borrower determines their strategy he or she is ready to evaluate refinancing options.

In this article we are assuming that your property qualifies for a new loan and that you don’t have to pay the transaction costs, including prepayment premium, out of your pocket, but can build it into your new loan. We will also assume the goal is not to take out cash from the refinance. This allows us to just look at the economic cost/benefit analysis of a refinance and not other issues like raising additional capital or the alternative return on cash proceeds from a refinance.

The analysis most borrowers use in evaluating refinancing and paying a prepayment penalty is a payback calculation. Most use either a cash flow payback by comparing the payments on the old loan to the new loan; however, some use a more through interest payback analysis by comparing the interest payments on the two loans. The cash flow payback is easy to calculate and while the interest payback analysis will require you to run an amortization schedule for each loan it’s also relatively easy to calculate.

Let’s look at one real-time example. I have a client; call him Mike, who refinanced a property 2 years ago with a bank for $2,050,000. The Bank loan had a typical 5-4-3-2-1 prepayment premium. The loan had a 6% rate and 3 years remaining before the loan matures. His current loan balance is just over $2,000,000. His prepayment penalty is $59,966.38. If he refinanced today into a 10 year fixed rate loan, the interest rate would be 4.5% with a 30-year amortization schedule. However, he would have to borrower about $2,100,000 to pay the prepayment premium and all the transaction costs of the refinance.

Rate | Loan Term | Original Loan Amount | Amortization | Monthly Payment | |

Current Loan | 6.0% | 5 Years | $2,050,000 | 30 years | $12,290.79 |

Proposed Loan | 4.5% | 10 Years | $2,100,000 | 30 years | $10,640.39 |

A simple payback analysis would show that Mike is saving $19,804.78 per year or $59,414.35 over the remaining 3 years of his current loan. This method of analysis shows that it is is pretty much a wash between the cash flow savings and the cost of the prepayment penalty.

While comparing the payments is a good way to evaluate the refinance it ignores the fact that part of your payment isn’t really a cost, but a reduction in principal. Therefore, a more complete method would be to compare the different interest payments under the current and proposed loans. For this analysis, we will need to run a full amortization schedule for each loan and compare the interest payments over the next three years. Doing this will show us that under the current loan Mike will be paying $357,119 in interest over the next 36 months, while under the proposed loan he will be paying $271,069. Therefore, in this second method of analysis the proposed loan will save make $86,050 in interest over the remaining term of the loan vs the $60,000 cost of the prepayment premium.

Comparing the savings under each scenario to the cost of the prepayment premium/penalty shows that refinancing is either a wash or saves Mike money to refinance. Someone might say we are not considering the other transaction costs in this analysis; but since these costs will have to be paid at refinance in 3 years anyway we should be able to ignore them in this cost benefit analysis.

In either analysis, Mike gets some additional benefits besides the payback. First, he gets the benefit of the additional cash flow in his pocket; while the costs of the refinance are part of the new loan, so his personal cash flow is increased, while the costs are deferred for 10 years. Second, he gets to lock in his rate for an additional 7 years at historic low rates and, therefore, eliminates the risk that rates will increase before he refinances.

I have focused this analysis on a simple step-down prepayment, but it can also be used in the case of a yield maintenance prepayment premium. The principles are the same, just the numbers are different.

Let’s use another example, I have another client; call him Tom, who bought a property 8 years ago and took out a loan for $10,000,000. The loan was a 10-year balloon mortgage at 5.95% with a 9 ½-year yield maintenance period. Today he has an unpaid mortgage balance of 8,778,773 and a yield maintenance prepayment premium of 800,692 (9.12% of the outstanding principal balance). Let’s look at what would happen if he refinanced today.

In order to refinance the loan today, Tom would have to borrower $9,690,000 to pay off the existing loan and pay the prepayment premium and transaction costs.

Rate | Loan Term | Original Loan Amount | Amortization | Monthly Payment | |

Current Loan | 5.95% | 10 Years | $10,000,000 | 30 years | $60,165.06 |

Proposed Loan | 4.25 | 10 Years | $9,690,000 | 30 years | $48,004.42 |

The simple cash flow payback analysis would show that Tom would be saving $12,160.64 per month or $291,855.36 over the remaining 24 months before his yield maintenance expires and he can refinance with no penalty. The interest rate payback analysis show you that under the current loan Tom will be paying $1,192,271.40 in interest over the next 36 months while under the proposed loan he will be paying $821,647.11. Therefore, the proposed loan will save him $370,634.29 in interest over the remaining term of the loan. Comparing these savings to the prepayment penalty of over $800,000 shows Tom should not refinance the loan, yet.

This analysis is helpful, and for borrowers who are focused on cash flow it may be about all the analysis you need. However, this analysis does not really ask the correct question. What a borrower is really trying to determine is not to keep the current loan or refinance today, but to refinance today or at a future time, usually when the current prepayment penalty expires. The payback analysis ignores a couple of important facts: first, the fact that the balloon balance and therefore borrowers equity are different under the two loan scenarios; second, it ignores where interest rates will be in the future when the current loan matures. In order to take these facts into account, you need to make a more complex calculation that includes numerous assumptions. A future post, I will be addressing this issue. In the meantime if you need assistance analyzing whether you should refinance your existing loan, please feel free to contact me.

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