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Prepayment Fees on Corporate Loans
When interest rates go down, business owners inevitably compare their existing
loan rates to the current market rates and wonder if they couldn't reduce their
loan payments by refinancing. The problem is that a corporate loan, especially
one with a fixed rate, may require a prepayment penalty fee if the loan is paid
down, or paid off, prior to its scheduled maturity.
The Reasons For Prepayment Fees
Prepayment fees protect lenders who extend fixed-rate loans. The reasons
this protection is essential are two fold. First, the bank may be "match
funded." That means a fixed-rate loan is funded with a certificate of deposit
(CD) or other form of liability, which matches the term of the loan. If the
borrower prepays, the lender loses the fixed rate income, but must continue to
pay the related fixed rate expense of the matching liability. The prepayment
fee compensates the lender for the resulting mismatch and loss of income.
The second reason for prepayment fees involves the lender's heavy investment in
up-front expenses to underwrite and approve a loan. The prepayment fee recoups
that up-front expense and the loan is paid before its scheduled maturity.
Understanding Different Approaches
The two most common types of prepayment fees are percentage based and
market based. The percentage-based fee is calculated as a predetermined
percentage of the prepaid amount. At Dollar Bank, for example, a five-year
fixed-rate loan might call for a prepayment fee of 5% in the first year of the
loan, decreasing 1% each year thereafter. This means that if the loan were
prepaid by $100,000 in the third year of the loan, the prepayment fee would be
$3,000 ($100,000 x 3%).
The other type of prepayment fee is market based, which means that the lender
is compensated for the difference between the income, which is lost by virtue
of the prepayment (the original fixed rate) and the prevailing interest rate
(market rate) at which the lender can reinvest the prepaid funds for the
remaining term of the loan.
Because of the dramatic decrease in interest rates over the past few years, a
market-based prepayment fee can be substantially higher than a percentage-based
fee. For example, let's assume that a borrower took on a fixed rate loan at 10%
for five years. Three years later interest rates decrease to 8.5%, and the
borrower prepays $100,000. The lender loses the 10% income on that $100,000 for
remaining two years of the original loan, and is able to reinvest the prepaid
amount at only 8.5%, a loss of 1.5% in potential income for that period. In
this example, the prepayment fee would be about $3,000 ($100,000 times 1.5% for
two years). This is a simplified example. Some formulas for determining
market-based prepayment fees may be complicated, so read your loan agreement
carefully.
What You Can Do
Can you negotiate the fee with the lender when you decide to prepay? Yes,
but you may not have much success. Banks tend to stand firm on such fees. If
you are trying to refinance your loan with the same financial institution, one
possible compromise is to ask for a lower prepayment fee in exchange for a
higher rate on the refinanced loan---higher than prevailing rates, but lower
than the fixed rate you already have.
Notwithstanding the prepayment fee you might have in your current loan
agreement, today's low rates may make it worth refinancing your existing
fixed-rate loan. Keep in mind, however, that there may be other costs
associated with the prepayment, including legal fees and tittle costs on the
new loan.
When reviewing the prepayment language in the new loan agreement, consider the
possible consequences of a market-based or percentage-based prepayment fee in
relation to where you think interest rates are heading. Finally, you may want
to consider a floating rate loan with a minimum and maximum rate ("floor" and
"ceiling"). The prepayment fees may be the same, but you get to enjoy the
benefits of a floating rate while fixing your costs within acceptable
parameters.
To talk with a Dollar Bank
representative about your needs,
click here.
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