Understanding Prepayment Penalties

Mortgage loans are expensive to originate.  It is not uncommon for consumer mortgages to cost upwards of $9,000.  Lenders typically recoup those costs through a combination of upfront fees and interest revenue over the life of the loan. 

If a borrower pays off a loan shortly after origination, the lender is at risk of losing money on the loan. Enter prepayment penalties.  A prepayment penalty is a contractual clause that states the borrower is going to pay the lender an additional fee if the borrower pays the loan off early.  This really isn’t a penalty at all.  It is a way for the lender to make sure they don’t lose money on a loan.

For example a standard prepayment penalties with a 5 year structure of 5/4/3/2/1 structure. This means that if the borrower pays off the loan in year one, they have a 5% prepayment penalty, in year two, a 4% prepayment penalty, in year three, a 3% prepayment penalty, and so forth. So, you might be wondering how this affects the borrower, and the answer is, it depends on your investment strategy. Let’s dive in.

The rental investors looking to grow a legacy of rental properties and hold on to them long term (we call these properties “permanent rentals”) are not really affected by the prepayment penalty.  Since their investment strategy focuses on the lifetime of the loan, paying off the loan in the first five years is a moot point.

On the other hand, investors looking to purchase rental properties with flexibility to sell in the foreseeable future (we call these properties “transitional rentals”) are very concerned about the prepayment penalty. These investors are interested in market conditions and want to be able to sell the property at the right time without worrying about paying a penalty fee.

Free Business And Real Estate Investing eBooks

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Welcome to Winston Rowe and Associates knowledge blog, scroll down to the right for posts about commercial real estate.

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Real Estate Investing Articles

This is a link to 1226 real estate investing articles written by industry veteran’s.

25 Productivity Tips for Successful Business Owners

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Business Loans Uncovered

Knowing if you qualify is one of the most important things to know when applying  for a loan of any type. Blindly applying for a loan and being declined increases the chances of you being declined again and again because you not only lower your credit score each time you apply, multiple inquires also serves a red flag to other lenders and as a result lenders put you in a high risk category and charge higher interest rates in the event of an approval Includes: ​Traditional Lenders, Government Sources, The 7(a) loan guarantee program, SBA Low Doc loan program, SBA Express loan program, Factoring, Venture Capitalists, Angel Investors.

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Marketing Strategies for Real Estate Photography

One of the biggest problems that real estate photographers have once they have set up their business as a legal entity, obtained all the right equipment and perfected their technique is obtaining new clients.

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Books by Dr William Edward Deming

William Edwards Deming (October 14, 1900 – December 20, 1993) was an American engineer, statistician, professor, author, lecturer, and management consultant.

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Mezzanine Loans in Plain English

Mezzanine Loans

What Is Mezzanine Financing?

Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid.

Mezzanine debt has embedded equity instruments attached, often known as warrants, which increase the value of the subordinated debt and allow greater flexibility when dealing with bondholders.

Mezzanine financing is frequently associated with acquisitions and buyouts, for which it may be used to prioritize new owners ahead of existing owners in case of bankruptcy.

How Mezzanine Financing Works

Mezzanine financing bridges the gap between debt and equity financing and is one of the highest-risk forms of debt. It is subordinate to pure equity but senior to pure debt. However, this means that it also offers some of the highest returns when compared to other debt types, as it often receives rates between 12% and 20% per year.

Companies commonly seek mezzanine financing to support specific growth projects or acquisitions. The benefits for a company in obtaining mezzanine financing include the fact that the providers of mezzanine capital are often long-term investors in the company.

This makes it easier to obtain other types of financing since traditional creditors generally view a company with long-term investors in a more favorable light and are therefore more likely to extend credit and favorable terms to that company.

A number of characteristics are common in the structuring of mezzanine loans, such as:

  • In relation to the priority with which they are paid, these loans are subordinate to senior debt but senior to common equity.
  • Differing from standard bank loans, mezzanine loans demand a higher yield than senior debt and are often unsecured.
  • No principal amortization exists.
  • Part of the return on a mezzanine loan is fixed, which makes this type of security less dilutive than common equity.
  • Subordinated debt is made up of a current interest coupon, payment in kind and warrants.

Preferred equity is junior to subordinated debt, causing it to be viewed as equity coming from more senior members in the structure of the capital financing.

Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid It offers some of the highest returns when compared to other debt-linked financing types, as it often receives rates between 12% and 20% per year.

Mezzanine loans are most commonly utilized in the expansion of established companies rather than as start-up or early-phase financing.

The Pros and Cons of Mezzanine Financing

Mezzanine financing may result in lenders gaining equity in a business or warrants for purchasing equity at a later date.

This may significantly increase an investor’s rate of return (ROR). In addition, mezzanine financing providers receive contractually obligated interest payments monthly, quarterly or annually.

Borrowers prefer mezzanine debt because the interest is tax-deductible. Also, mezzanine financing is more manageable than other debt structures because borrowers may figure their interest in the balance of the loan.

If a borrower cannot make a scheduled interest payment, some or all of the interest may be deferred.

This option is typically unavailable for other types of debt. In addition, quickly expanding companies grow in value and restructure mezzanine financing into one senior loan at a lower interest rate, saving on interest costs in the long term.

However, when securing mezzanine financing, owners sacrifice control and upside potential due to the loss of equity. Owners also pay more in interest the longer mezzanine financing is in place.