In this era of compressing margins and volatile rates, not having a prepayment provision on your loans is likely costing your bank a material amount of income. A well designed prepayment provision for a commercial term loan can increase loan yields by up to 75 basis points – that is real money. A prepayment provision serves to extend loan duration, increase lifetime customer value, decrease one-way optionality given to the borrower (increases loan value), increase cross-sell opportunities and provide portability to the borrower – all serving to enhance income for the bank. However, some banks do not have clear policies on prepayment provisions and many include prepayment provisions only as an afterthought. In contrast, national and regional banks, insurance companies and conduits are very fastidious about prepayment penalties. This is one reason why we see lower spreads but higher ROA on loans from these entities – the prepayment provision more than offsets the profitability for the loan.
Don’t Use a Step-down Prepayment Structure
If your bank does use a prepayment provision, chances are it uses a step down structure. This is by far the most common prepayment provision. For example, on a 5-year loan, the bank may charge a 3%-2%-1% or 2%-1%-1%. The borrower pays the number (expressed as a percentage) times the loan amount corresponding to the year of prepayment. Under a 3-2-1, the borrower would pay 3% of the loan amount prepaid in the first year. The only advantage of this prepayment provision is its simplicity. The disadvantages are substantial. First, because it is hard for a banker to explain why the bank needs the provision for economic reasons, the provision is typically difficult to sell to a borrower. Thus, it is diluted (what starts off as a 5-4-3-2-1 initial proposal is often pushed back to a 3-2-1). Second, enforcement also becomes an issue. While contractually binding, the borrower will complain about paying it and banks often succumb to waiving it under threat of reputational risk. Third, and most importantly, the structure is completely disengaged from any market, credit or interest rate movement. This provision adds minimal value to the loan. But then again, it is easy to use and requires little strategy or forethought.
A lock-out prohibits any prepayment during a specified period. This provision is rare, but we see it utilized to very interesting effects in municipal financing. For example, the borrower will obtain a 10-year loan without contractual ability to prepay in the first 5 years and then prepay without any consequences (as an example) after the initial 5-year period. The provision has the effect of increasing yield for lenders by well over 50bps. However, the provision is rarely acceptable for most commercial borrowers.
This provision is used extensively by insurance companies and conduits. It is extremely disadvantageous to borrowers. The provision is rarely properly explained to borrowers and we have never seen a borrower presented with a termination scenario before the loan is executed – because the borrower would never signup for the provision if they understood the cost. We have seen borrower’s eyes pop out when they came to prepay the loan and the prepayment cost was 10, 15, 20 or even 30% of the loan amount. The provision is calculated as the present value difference between the all-in rate on the loan and the equivalent term treasury rate. If you’re not a math geek, just consider this: we recently saw a borrower (unwittingly) agree to a defeasance provision for a 25-year, due 15-year term loan, and on day one the prepayment cost was 38% of the loan amount. Our advice to bankers - avoid this provision for reputational reasons.
This is our favorite prepayment provision for commercial loans because it is self-aligning with borrowers, easier to substantiate and enforce, common to what other larger banks are currently using and allows for some very interesting applications. This provision trues up, or creates a neutral cost/benefit for a prepayment based on interest rate movements. Stated another way, the borrower becomes indifferent, from interest rate movement perspective, to prepayment, whether rates are higher or lower. For example, if rates drop the borrower’s cost for a new loan is lower and is completely offset with the prepayment cost on the existing loan. Conversely, if rates rise, the borrower receives a fee for a prepayment and that fee completely offsets the higher cost of a new loan with that higher rate.
This provision aligns the borrower’s view if that borrower expects rates to rise (borrower actually collects a fee). Also, the provision is standard for all national and the bigger regional banks. So we find borrowers are educating some bankers on the provision because they had it explained to them by the competition. The reason that borrowers sign up for the provision is because they accept the fact that the bank has a true cost of loan prepayment if rates are lower, and likewise, the bank has a true benefit of a loan prepayment if rates are higher and the benefit is shared with the borrower.
But the main reason why we like this prepayment provision is the flexibility it offers the borrower and lender for future financing. The provision makes the loan assignable and assumable. That is a very powerful feature when interest rates are very low but expected to increase over the term of the loan (5, 7, 10 or even 20-year period). The provision can also be modified to create no prepayment windows, partial prepayment windows or prepayment windows based on preset fee amounts – of course, the modifications all come with some bump in rate and paid by the borrower.
For community banks that believe that they are underpaid for their commercial loans, one area where yield can be enhanced is properly structuring a marketable prepayment provision. A properly structured prepayment provision can increase effective yield on a commercial loan by many basis points – many more basis points than most banks can now price over an index. The average bank may not be able to earn 3.50% over its long-term cost of funding. However, the bank can still price the loan at 2.75% over the index and obtain the remaining 75 basis points through a correct prepayment structure. If your bank is not familiar with the symmetrical breakeven prepayment provision, you can download a file (HERE) that contains both the language for the provision and a dynamic termination scenario in Excel.
Submitted by Chris Nichols on March 09, 2016