Borrower’s Burden: Can a Co-op/Condo Get a Loan with No Prepayment Penalty?

The logic behind prepayment penalties is a little easier to understand if you think of a loan as an investment or a contract. Under a loan agreement (usually referred to as the “note”), a lender agrees to provide the borrower with a certain amount of money (the “principal”) for a specified period of time (the “term”) in exchange for a rental fee (the “interest”).

This is much like an investor who buys a certificate of deposit (CD) from a bank, expecting to receive a fixed amount of interest until the CD matures. If, prior to the CD’s maturity date, the bank were to cancel it and return the investor’s money, the investor could rightfully expect some form of compensation (or penalty) from the bank for breaching the agreement.

Borrowing Basics

When a borrower closes a loan, he or she enters into a contract with the lender, and this contract comes with certain rights and obligations for each party. The borrower has the right to use the lender’s money for the duration of the loan term and the obligation to make the required payments of interest (and sometimes principal) when they are due. The lender, having made an investment in the borrower, has the right to expect the rate of return that was specified in the contract (i.e., the interest rate) for the duration of the loan term. If the borrower decides to breach the contract by prepaying the loan before the maturity date, the lender is entitled to compensation in the form of a prepayment penalty.

While a yield maintenance prepayment penalty remains very prevalent in underlying mortgage loans, competition among lenders has resulted in a number of interesting alternatives. For a new 10-year loan, some lenders might impose yield maintenance for the first five or seven years and then switch to a declining percentage. Other lenders have abandoned yield maintenance altogether in favor of a declining percentage formula for the entire term. Even if a lender offers you a loan with yield maintenance, you always should ask whether there is another option.

As a final note, I would like to mention that prepayment penalty formulas are relevant only if you have to prepay. Prudent financial planning, annual budgeting of contributions to the co-op’s reserve fund, and second mortgage credit lines can obviate the need to prepay an existing underlying mortgage for most buildings.

Patrick B. Niland, a mortgage broker, is the principal of First Funding of New York.

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