Prepayment penalties, or “prepayment premiums” as we prefer to call them, are the charging of a fee in lieu of interest that would have otherwise been collected if the loan had not been paid of prior to a certain date. Lenders expect to receive interest income from the monthly payments on any given loan, and when the loan is paid off early, the income is less than expected. To make up for this loss, lenders often require the borrower to pay a fee, a premium, or more colloquially referred to as a “penalty”.
The method of calculating the premium can take many forms, though some of these forms are prohibited in certain states, others prohibit the premium altogether, and others simply put a cap on the amount being paid or a time limit on when they can be collected. This article will explore the common formats of prepayment premiums, the state law limitations that are often found, and how there may be limitations even in the absence of a specific state law.
Structure of Premiums
The structure of the premium can be made in many formats. These include an amount equal to:
- The interest that would have been paid between the date of the payoff and a future cutoff date;
- A specific dollar amount;
- A static percentage of the amount paid off; or
- A variable percentage of the amount paid off
The amount of the premium and the determination of a cutoff date, or a date in which the amount owed changes, is up to the parties to decide and may be as creative as one would like.
Limitations
However creative the parties may be, state law may limit the amount, the time frame, or even the use of a premium altogether. The limitations are often determined with respect to the following factors:
- The dollar value of the loan,
- Whether the borrower is an entity or an individual,
- Whether the property is residential or commercial,
- Whether the property is owner-occupied,
- Whether the lien is senior or junior, or
- A combination of some or all of these.
For example, in Illinois, if the borrower is an individual, the property has 1-4 residential units, and the interest rate is greater than 8%, then prepayment premiums are prohibited entirely. In Michigan, if the property is a single family, then the premium cannot exceed 1% of the amount prepaid during the first 3 years after closing, and no premium at all after that.
When there is no state law directly limiting or prohibiting prepayment premiums, their use will always be subject to the common law prohibition on “penalties”. It is for this reason that we choose to use the term “premium”. Penalties are generally not enforceable. Instead, the law uses the term “liquidated damages” to denote a certain amount of money to be paid at the occurrence of an identifiable event for which actual losses are difficult to calculate or are uncertain. As a result, premiums that are exceedingly large in relation to the amount of interest that would be lost, a court could determine it is a penalty and refuse to enforce it. We recommend careful usage of prepayment premiums, in particular those which call for a specific dollar amount which does not diminish over time as more interest is paid which would otherwise limit the lender’s losses.
Avoiding Issues
Prepayment premium limitations are a creature of state law, therefore the law that governs the loan documents will be the law that governs the prepayment premium. For example: A loan where the property is in Michigan, but the lender operates out of North Dakota. The lender could use North Dakota law to govern the loan (other than the deed of trust securing the property) and because North Dakota law has no limitations on prepayment premiums, the lender could avoid the limit otherwise present in Michigan.
Significant caution should be exercised in choosing the governing law of a loan. There must be a proper “nexus” between the parties, the property, and the loan for a certain choice of governing law to be enforceable. We strongly recommend that an attorney is consulted before making governing law decisions.
Concluding Thoughts
Prepayment premiums are a wonderful tool for lenders to mitigate the risk of an early payoff, but particular attention should be paid to state law compliance in this area as the differences between states is significant, and the limitations provided are often complex. The attorneys at Geraci LLP are experienced in navigating through these limitations and are happy to provide guidance on specific loan scenarios, and to avoid the premium being determined as a penalty. Reach out to us with any questions you may have.