Know the Cost of Prepaying a Loan

October 18, 2017 01:02 PM

I know a producer who took out a 20-year loan for roughly $17 million a few years ago, when times were more prosperous. Like many farmers and ranchers today, he’s been forced to refinance with another lender to unlock the equity in the real-estate collateral that backed his original loan. By refinancing, he can access more money, which his farm operation needs today. But paying off his original loan early has come at an enormous cost: a “prepayment penalty” of nearly $5 million.

You might not expect to pay off your loan before it matures—but this can, and does, happen. As debt restructuring increases among farmers and ranchers in this low-price environment, it’s important to be aware of prepayment penalties before you sign a loan contract.

Prepayment penalties are built into loan contracts for two reasons: to compensate the lender for losing out on the interest it expected to make on the loan and to prevent customers from leaving prematurely. If you pay off the loan before it matures, the lender doesn’t make the full return on its investment.

One common prepayment penalty provision found on loan contracts uses a “step down” structure. It’s a calculation based on the remaining balance of the loan. The penalty amount shrinks the longer the loan is in place. There are different step-down structures, such as “3-2-1.” For example, if you prepaid your loan in the first year, the penalty would be 3% of the outstanding balance. The penalty would drop to 2% in th second year and 1% in the third year.

Another common prepayment penalty is based on a flat rate. A bank might require you to pay 1% or 2% of the remaining loan balance, no matter when you prepay.

A more complicated fee is the “make whole” provision. This can be complicated, partly because lenders often are reluctant to share how they arrive at the penalty calculation. But the bottom line is you’ll pay an amount that makes the lender “whole” on the return it expected from carrying your loan to maturity. Because the goal is to make the lender whole, there are circumstances where market conditions change and terminating the loan early will benefit the lender, thereby eliminating the fee.

I urge you to understand the prepayment penalties before you accept the terms of a loan. Know what you’re agreeing to and your risks, such as:
■ Know your repayment time frame. While circumstances can change, knowing your expected repayment timeline can help you and your lender avoid a poor structure with crippling prepayment fees.
■ Talk to your lender upfront about your options. Try to avoid a “make whole” provision and opt for a simpler, more transparent and shorter-lived fee.
■ Understand how your prepayment penalty is calculated. This might be difficult to obtain, but be persistent. It can help you understand your risks. Your borrowing decision might be clearer, for example, if you know a long-term, fixed-rate loan comes with higher prepayment penalties, despite the advantages of a locked-in rate.

Prepayment penalties and make-whole provisions are common and shouldn’t scare you from a great rate and loan structure. However, regardless of the size of your loan, take the time to understand the prepayment penalty and its potential impact.

Peter Marin is a columnist for Farm Journal. As a finance and growth consultant with K·Coe Isom,
Martin helps businesses identify opportunities, source capital and manage expansion challenges.

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