Prepayment Penalties: An Unwelcome Surprise

Whether you have applied for a loan or are thinking about doing so, it is important to consider whether you could be charged a fee for paying the loan off early. Too many borrowers never consider the impact that an unexpected fee could have on their ability to refinance the loan, to sell property, or to make other critical business decisions.

You may be surprised to find out that in Maryland, borrowers do not have the right to pay off a mortgage loan prior to the agreed-upon maturity date unless specifically permitted by a statute, the loan documents themselves, or another agreement between the borrower and the lender.  Unless one of these exceptions applies, the lender can refuse to permit the borrower to prepay the loan, and can insist that the borrower repay the loan at the originally agreed time.  This rule, known as the “perfect tender in time” rule, has been recognized as the law in almost every state.

In most cases, borrowers and lenders include language in the loan documents that will allow the borrower to prepay the loan, but often only if the borrower agrees to pay the lender a prepayment fee. The purpose of the prepayment fee, at least in theory, is to make the lender whole and allow it to recover the benefit of its investment in making the loan, rather than penalizing the borrower for paying it off early.

Prepayment fees are prevalent in commercial loans, where they can be structured in many different ways. If you are negotiating a loan, it is critical to understand whether a prepayment fee will apply, the circumstances that could trigger the prepayment penalty, and how much the prepayment penalty will be. Prepayment fees are almost always triggered by the borrower’s voluntary prepayment of the loan, such as a refinance, but there may be other circumstances which could also trigger the prepayment fee. For example, if the property securing a loan is condemned or destroyed by a fire or other casualty event, the lender usually has the option to require the borrower to apply the proceeds of the condemnation award or the insurance proceeds to the outstanding balance of the loan.  Depending on how the loan documents are worded, the lender may be entitled to collect a prepayment fee in these circumstances.  In addition, lenders commonly have the right to collect a prepayment fee when the borrower defaults on the loan and the lender accelerates the outstanding balance of the loan.

The amount of a prepayment fee may be determined in many different ways. The prepayment fee may be a flat fee or a percentage of the outstanding balance of the loan, and the amount may or may not decline as the loan gets closer to the maturity date. Commercial loans often determine prepayment fees using a yield maintenance formula, which calculates the fee based on the amount needed to equal the lender’s projected return under the terms of the loan compared to what the lender would earn if the prepaid funds were re-invested in another form of investment, usually treasury securities.  Many lenders draft their yield maintenance premiums in such a way that the lender will always be entitled to a prepayment fee, even if interest rates have risen since the loan was made.  In a rising interest rate environment, the lender could reinvest the prepaid funds at a higher rate, actually resulting in a gain for the lender instead of a loss. Requiring the borrower to pay a prepayment fee in these circumstances can create a windfall for the lender.

Unsurprisingly, there has been a great deal of litigation by borrowers challenging the enforceability of prepayment fees. As a general rule, courts are less likely to enforce a prepayment fee when the circumstances giving rise to the prepayment are truly involuntary, such as a bankruptcy or a condemnation or a casualty event.  In those cases, the courts tend to look narrowly at the language in the loan documents and evaluate whether the amount of the prepayment fee fairly and accurately estimates the lender’s damages from prepayment. In these circumstances, clear and unequivocal language in the loan documents is crucial to determining whether the prepayment fee is enforceable.

However, in situations where the borrower wants to voluntarily prepay the loan to take advantage of more favorable interest rates or business opportunities, courts are generally willing to enforce prepayment clauses in accordance with their terms, even when it would appear to result in an unreasonably high prepayment fee. For instance, in Carlyle Apartments Joint Venture v. AIG Life Insurance Co., 333 Md. 265, 635 A.2d 366 (1994), the Maryland Court of Appeals enforced a clause calling for a yield maintenance fee without even considering whether the amount of the fee might constitute an unenforceable penalty rather than a reasonable estimate of the lender’s actual damages. The court reasoned that under the perfect tender rule, the borrower would not have been entitled to prepay the loan at all. Thus, allowing the borrower to prepay the loan was a form of “alternative performance” under the loan contract that the parties had bargained for.  The court was willing to defer to the parties’ freedom to contract without even looking at whether the amount of the prepayment fee was reasonable.

Before signing on the dotted line, make sure that you carefully read the loan documents and understand whether any prepayment fees will apply to the loan, and if they do, under what circumstances and in what amount. Having your loan documents reviewed by a qualified attorney who can review and negotiate these provisions on your behalf can be the key to avoiding nasty and expensive surprises later on.

For questions about this article or any other real estate law related matter, please contact an attorney in our Real Estate Law practice group.