Prepayment Penalties

Patrick Niland is president of First Funding, a mortgage brokerage firm. Send your questions to tsoter@habitatmag.com
I recently was elected treasurer of my cooperative. I had thought that my first official act would be to refinance our underlying mortgage to lower our interest cost and raise about $400,000 for needed capital improvements. However, I just learned from our accountant that our existing loan has a “yield maintenance” prepayment penalty that might be more than we can afford. First of all, what’s yield maintenance? Second, what do I do now?

You’d have all of the options you thought you had – plus a few more – were it not for your prepayment penalty. Unfortunately, virtually all underlying mortgages have one. The less onerous penalties are based on a flat percentage of your outstanding balance, and that percentage declines over the life of your loan. For example, on a 10-year loan, the penalty could be five percent during the first two years, four percent during the next two years, then three percent, two percent, and one percent for each succeeding two-year period. A few lenders still offer this form of prepayment penalty.

Most lenders, though, have switched to your form of penalty. A “yield maintenance” prepayment penalty does just what the words say; namely, it maintains the yield of the loan for the lender. When a lender makes a loan, it signs a contract to provide the borrower with a certain amount of money for a set period of time in exchange for a predetermined amount of interest. If a borrower breaks this contract by paying off the loan before the maturity date, the lender must re-invest the proceeds by making another loan to a different borrower at the then-prevailing rate.

If rates have fallen in the meantime, the lender might earn less interest on this new loan than it would have on the old one. Rather than take that risk, many lenders impose prepayment penalties that require the borrower to pay them the present value of the interest that they would have earned had the borrower not prepaid. In other words, the penalty “maintains” the lender’s “yield” from each loan whenever the borrower chooses to break the loan contract by prepaying. This is the same principle that bankers use to justify penalties when investors cash certificates of deposit (CDs) before their maturity dates.

Because of the way they are calculated, yield maintenance penalties usually outweigh the economic benefit of refinancing. However, that is not always the case. At certain times in the interest rate cycle (like in the past year or so), the savings from refinancing are so great that they recoup both the closing costs of refinancing plus very substantial prepayment penalties within just a few years. That’s why I always recommend that board members “run the numbers” before they reject the idea of paying a prepayment penalty.

Depending on what your numbers show, the best solution for your situation might still be a refinancing. If not, there are other options to consider. You might look for a credit line or a second mortgage. Credit lines operate much like an overdraft privilege on your personal checking account. A bank agrees to lend your cooperative up to a certain maximum amount, to be drawn down as you need the funds (usually in increments of $5,000 or $10,000). You pay interest monthly, at a floating rate (say, prime plus one to two percent), on whatever balance was outstanding during the previous month. This arrangement usually lasts for a limited period of five or ten years, after which the outstanding balance must be repaid.

Second mortgages are very similar to your first mortgage, though usually smaller. They typically have a fixed interest rate and the same maturity date as your first mortgage. Second mortgages are somewhat harder to find, but I tend to recommend them over credit lines – especially for capital improvements. Credit lines are fine for emergency needs, but permanent additions to your building’s physical plant should be funded with fixed-rate debt. It is imprudent to expose your cooperative’s budget to variable-rate debt on a regular or long-term basis.

Of course, there always is the old stand-by solution of an assessment. Many boards find assessments to be politically unpopular, while others prefer the “pay as you go” nature of assessments. On one level, I agree with this latter logic. However, assessments deprive shareholders of the ongoing tax benefit generated by loan interest. They also have been shown to depress the market value of apartments under certain circumstances. So, assessments should be considered very carefully.

You also could raise maintenance. However, aside from the negative reaction that this action might cause, you’ll need either a very large increase or a very long time to raise the $400,000 you need to pay for planned capital improvements. Another alternative would be to borrow the money from one or more well-heeled shareholders. They might be delighted to withdraw their money from a money market fund paying just three percent and lend it to the cooperative at, say, eight percent. Or you could approach another cooperative that has a large reserve fund and borrow money from them.

A final (tongue-in-cheek) suggestion would be to take whatever money you have in your reserve fund and buy lots of lottery tickets. If you win, you’ll be a hero. If not…well, let’s just say that you’ll be living in a different kind of “apartment.”