One of the major factors to consider when applying for a loan on commercial real estate in Texas is the prepayment penalty or as we say in the business: PPP. (And by commercial real estate we mean non-homestead residential, multi-family, mixed-use and commercial properties.) Depending on the term of the loan and source of funds, the prepayment penalty can vary wildly and can significantly impact how expensive the financing is for you. Understanding the different types of prepayment penalties is critical to determining how the loan fits into your real estate investment strategy.
What is a prepayment penalty?
Prepayment penalties are amounts that you’re liable for if you pay off or refinance the loan before a certain amount of time has passed. The primary purpose of PPPs is to guarantee the lender a certain return on the money they’ve invested in the loan. If the borrower pays off the loan within a couple of months, then that wouldn’t be a loan worth making because the lender ROI would be so small that it wouldn’t be worth it for them to deploy the funds in the first place. Thus, the prepayment penalty is born which “protects” the lender under early payoff situations. PPPs also help the lender estimate when loans will pay off so that they can plan to redeploy the funds efficiently.
Texas Prepayment Penalties
First off, prepayment penalties are not even legal in some states, and sometimes they’re only allowed on certain property types or with certain loan amounts. It seems that every state has a slightly different take on how to handle them. But, since we’re a Texas-only lender, we can simply focus on Texas and ignore the national patchwork of regulations. So here’s the deal: In Texas prepayment penalties are allowed on all loans on any non-homestead commercial real estate including residential, multi-family, mixed-use and commercial properties.
You might say, “Hey, Texas, this is a bad deal for me! I have to pay just to pay off my loan?” But remember that that lenders don’t lend money for free and will get their return one way or the other, either through higher rates, more fees or PPPs. So ultimately it’s just another tool in the lender’s tool box. But at least with this one, you often have some control.
Types of Pre-Payment Penalties
There are two primary types of prepayment penalties: Fixed and declining. At Little City Investments, we employ both depending on the loan type and/or borrower preference.
Fixed Prepayment Penalties: Fixed PPPs are a set percentage of the loan amount that must be paid if the loan is paid off within a certain timeframe. The percentage doesn’t change. But if the loan is amortizing, the PPP amount naturally reduces over time since the loan principal is being continuously paid down. For example, if you have a 5% fixed, 5-year PPP, then if you pay off the loan at any time before five years, you would have to pay 5% of the remaining principal at payoff, which of course is much less at the end of the five years than at the beginning.
At Little City Investments, we also do fixed PPPs on interest-only loans which don’t pay down over time. We also sort-of have fixed prepayment penalties on our 1-year hard money bridge loans: We charge 4-months minimum interest on these loans which means if your loan pays off within 4 months you still have to pay that amount of interest. This would still technically be considered a PPP, but it just goes to show you how lenders can ensure a minimum amount is payed by the borrower.
Declining prepayment penalties: Declining or step-down prepayment penalties are just like they sound. Over time the PPP% decreases at regular intervals. For example, a 5%, 5-year declining PPP would step down 1% each year: 5-4-3-2-1. The timeframes for declining prepayment penalties are usually flexible just like fixed prepayment penalties. Declining prepayment penalties are only available on our long-term DSCR loans.
What Prepayment Penalty is Right for Me?
We understand that everyone’s situation is unique so we do our best to offer the most flexible PPPs we can. For our long-term loans, we offer timeframes from two years to five years for PPPs and you can often chose between fixed or declining. You can often choose the PPP % too. Your choice of prepayment penalty will depend on several factors including:
- If the PPP influences the interest rate. Shorter/smaller PPPs generally result in higher interest rates.
- How optimistic you are about interest rates being reduced in the future. You could refi at a lower rate, but that could be a wash when considering the PPP. Get your crystal ball out!
- If the PPP fits with your plans for the property. For example, if you’re not planning on selling or refinancing within five years, then the PPP duration wouldn’t matter and you would angle for the lowest interest rate.
At Little City Investments, we want to be your go-to lender for all of your short-term and long-term Texas real estate financing needs. We’ve been lending on Texas commercial real estate for over 20 years now and are quite the fount of knowledge for real estate investment at this point. If you’re in the market for a non-homestead bridge loan or DSCR loan, drop us a line and we’ll be happy to answer your questions and find the solution that’s right for you. We’ll get your deal done!