The question I get most asked is how does yield maintenance prepayment penalty work and should I be worried about it. This is especially true for borrowers who had previously borrowed from banks and are now looking at a loan from Freddie Mac or Fannie Mae. My short answer is that this is not something to worry about, but if you are taking a loan with yield maintenance you should not expect to pay it off until close to maturity because you will have a significant prepayment penalty.
First what is yield maintenance (YM)? It’s basically a calculation that guarantees the lender will receive the interest payment from the loan for the full term of the loan (or yield maintenance period). The idea is that if you pay back the loan early, the owner can reinvest the proceeds from the money you return to them, plus the penalty amount in safe treasury securities and receive the same cash flow as they would by holding your loan.
How is YM it calculated? All YM is not calculated exactly the same, but the general principal is the same. Basically it’s the difference (spread) between the note rate and the current yield on a specific treasury security that has the same remaining term as the loan (this is called the reinvestment rate). This spread is multiplied by the remaining term and then discounted back to current dollars. A rough way of determining the penalty is to subtract the treasury rate from a security with the same remaining term as the yield maintenance period (usually the loan term less 6 months) from the note rate. Then multiply that spread by the number of years left in the loan and multiply that by the loan amount. This result will be slightly higher than the actual prepayment penalty because we have not discounted the payments, but it should be close. As a kicker most YM loans have a 1% minimum prepayment penalty even if the calculation results in no penalty.
Some people say with rates this low you do not need to worry about a YM prepayment penalty because when rates rise the spread will be reduced or eliminated completely. The problem with this analysis is that as time goes on the remaining term of the note goes down. So you are comparing your note rate to a treasury with a shorter term. As long as there is a yield curve the rate on shorter term securities are less than on longer term maturities. This has the effect of increasing the spread between the note rate and the corresponding treasury.
To see if you really need to worry about YM we need to look at some real life examples.
The above chart shows a typical $1 million loan being offered today. The chart shows examples of 5, 7 and 10 year loans with a payoff in year 3, 5 and 7. The assumptions are that rates stay the same, increase by 1.5% from current rates, increase 3% from current rates or they return to the average rate for the last 10 years of a similar term treasury security. We can run these numbers with many different assumptions, but I think these assumptions show the trend.
As you can see under most circumstances you will have a prepayment penalty even if there are only a couple of years left in the loan term. With 2 years left on a 5 year loan you will have a 1% prepayment premium even if rates rise by 3% from current levels. Of course many people think rates will rise more than 3% and be higher than historical averages. If that is true then you might not have any prepayment penalty. If you think rates will rise higher then these assumptions then the question to ask is, will the corresponding treasury rate will be higher than the loan rate when I want to prepay. If the answer is yes they you will only have the minimum 1% to pay.
The analysis shows, you should expect a penalty for most of the life of the loan, but because rates are relatively low today the prepayment penalties are not outrageous. You should not expect to pay the crazy prepayment premiums we here today. Under most circumstances you will have a prepayment premium of a few percent of the loan amount not the 20% of loan amount you hear today.
If I am going to pay a prepayment penalty and sometimes a big penalty then why should I choose a loan with YM? The answer is twofold. First on most long term loans (over 5 years) there really is no option. YM or something like it is required on almost all loans. The second reason is that by guarantying the owner of the note that they will receive their interest for the life of the loan they are offering you the best rate. Typically rates on loans with YM are 50-100 Bps lower than similar loans with step-down or more flexible prepayment penalties.
The two biggest concerns about a YM loan are what happens if you sell the property or need to pull out more cash. However, most lenders who make loans with YM (Freddie and Fannie included) allow for their loans to be assumed by a qualified buyer. This means you can sell the property and just have the buyer assume the loan. Also, Freddie and Fannie have programs that will allow them to lend you additional proceeds in the future in the form of a second mortgage. There are restrictions and it does not always work, but it is there for some circumstances. Selling the property that has a low interest rate mortgage may even boost your value if the financing is assumable and the rate is below the levels a buyer can get in the current market.
While I think the rate trade off for a YM loan is reasonable and would choose a YM loan because of the lower rate there are a few things to consider. First, don’t just choose the longest term you can, try to match the loan term with the term you intend to keep the loan. Second, look at all features of the YM prepay. You need to look at the term of the YM as well as the amount of free time with no prepay. Most calculations are for a YM period of 6 months less than the loan amount, but some run the full term of the loan. Also, most YM loans call for only 3 months at the end with no prepayment premium, till then the 1% minimum is in place. Finally it’s possible to buy a shorter term YM on a loan, say 7 years of a 10 year loan. There is a cost to this, but depending on your real estate strategy the cost might be worth it.
In general you have little choice on your prepay if you want the lowest rate. However, you should understand the loan you are getting into. If you have any questions please talk to your real estate finance advisor or contactus@mfloan.com and we will try to assist you.