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When should I consider paying a prepayment penalty?

Thursday, Apr 23, 2015
by Jeff Meierhofer

Many commercial property owners purchased or refinanced their loans while things while the economy was smoking back in 2006-2008. Then the economy took a historical turn for the worst, which caused rates to drop to all-time lows. Let’s say you’re sitting on a loan with a right in the high 5’s, or even 6 or 7%.  You’d like to refinance to take advance to today’s rates before they hike back up, but you don’t want to pay that hefty prepayment penalty. Should you do it?

When our clients are considering refinancing, I ask them the following questions:

  • Are you going to hold this property for a long time?
  • Can you pull a bunch of cash out of this deal that you can re-deploy to a better yield?
  • Is your property at risk of suffering a large vacancy from an economic downturn?
  • Do you believe that interest rates will rise sooner rather than later?
  • Do you believe that having a low interest rate loan will enhance the property value if you sell during the loan term?

If the answers to the above questions are “yes” then you should seriously consider paying the pre-payment penalty and refinancing.

To make an intelligent decision, we first need to determine the prepayment penalty.  The best thing to do is order a pay-off from the lender.  Ask for a calculation assuming that your new loan will close ninety days out and that the loan is paid off on the payment date, so you don’t incur any extra monthly interest.

Most people only look at the actual pre-payment penalty number. What many people don’t take into account is the savings that you’re new lower rate and how the difference between those two numbers can make that prepayment penalty a lot more palatable. The interest savings over the first 2-3 years alone with the lower rate can sometimes wipe out the costs of the prepayment altogether.

If you had to refinance today, the odds of getting your fixed rate of below 5% on a ten-year fixed rate are actually pretty realistic. Of course the sooner your loan comes due, the lower the actual pre-payment penalty and the more sense this makes!

The Madison Group has executed fixed-rate financing for clients in the capital markets since 2001.  Give us an opportunity to review your transaction to see if financing now makes sense.

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