Offices & ATMs About Us Contact Us CashAnalyzer® Log In Search
Personal BankingBusiness BankingPrivate Banking
Dollar Bank - Business Center - Resources

Dollar Bank - Business Center - Prepayment

Prepayment Fees on Corporate Loans

When interest rates go down, business owners inevitably compare their existing loan rates to the current market rates and wonder if they couldn't reduce their loan payments by refinancing. The problem is that a corporate loan, especially one with a fixed rate, may require a prepayment penalty fee if the loan is paid down, or paid off, prior to its scheduled maturity.

The Reasons For Prepayment Fees
Prepayment fees protect lenders who extend fixed-rate loans. The reasons this protection is essential are two fold. First, the bank may be "match funded." That means a fixed-rate loan is funded with a certificate of deposit (CD) or other form of liability, which matches the term of the loan. If the borrower prepays, the lender loses the fixed rate income, but must continue to pay the related fixed rate expense of the matching liability. The prepayment fee compensates the lender for the resulting mismatch and loss of income.

The second reason for prepayment fees involves the lender's heavy investment in up-front expenses to underwrite and approve a loan. The prepayment fee recoups that up-front expense and the loan is paid before its scheduled maturity.

Understanding Different Approaches
The two most common types of prepayment fees are percentage based and market based. The percentage-based fee is calculated as a predetermined percentage of the prepaid amount. At Dollar Bank, for example, a five-year fixed-rate loan might call for a prepayment fee of 5% in the first year of the loan, decreasing 1% each year thereafter. This means that if the loan were prepaid by $100,000 in the third year of the loan, the prepayment fee would be $3,000 ($100,000 x 3%).

The other type of prepayment fee is market based, which means that the lender is compensated for the difference between the income, which is lost by virtue of the prepayment (the original fixed rate) and the prevailing interest rate (market rate) at which the lender can reinvest the prepaid funds for the remaining term of the loan.

Because of the dramatic decrease in interest rates over the past few years, a market-based prepayment fee can be substantially higher than a percentage-based fee. For example, let's assume that a borrower took on a fixed rate loan at 10% for five years. Three years later interest rates decrease to 8.5%, and the borrower prepays $100,000. The lender loses the 10% income on that $100,000 for remaining two years of the original loan, and is able to reinvest the prepaid amount at only 8.5%, a loss of 1.5% in potential income for that period. In this example, the prepayment fee would be about $3,000 ($100,000 times 1.5% for two years). This is a simplified example. Some formulas for determining market-based prepayment fees may be complicated, so read your loan agreement carefully.

What You Can Do
Can you negotiate the fee with the lender when you decide to prepay? Yes, but you may not have much success. Banks tend to stand firm on such fees. If you are trying to refinance your loan with the same financial institution, one possible compromise is to ask for a lower prepayment fee in exchange for a higher rate on the refinanced loan---higher than prevailing rates, but lower than the fixed rate you already have.

Notwithstanding the prepayment fee you might have in your current loan agreement, today's low rates may make it worth refinancing your existing fixed-rate loan. Keep in mind, however, that there may be other costs associated with the prepayment, including legal fees and tittle costs on the new loan.

When reviewing the prepayment language in the new loan agreement, consider the possible consequences of a market-based or percentage-based prepayment fee in relation to where you think interest rates are heading. Finally, you may want to consider a floating rate loan with a minimum and maximum rate ("floor" and "ceiling"). The prepayment fees may be the same, but you get to enjoy the benefits of a floating rate while fixing your costs within acceptable parameters.

back

Print Page
Contact Us

Contact Us Today:

Corporate Banking
  PA: 412-261-8849
  OH: 216-736-8938

Small Business Banking
  PA: 412-261-8130
  OH: 216-736-8998

Treasury Management
  PA: 412-261-7597
  OH: 216-736-7358

Dollar Bank Business Representatives are available Monday through Friday from
8:30 AM to 5:00 PM.

Access Your Account:

Privacy / Legal Equal Housing Lender. Member FDIC. Copyright © 2010 Dollar Bank, Federal Savings Bank. All rights reserved.
Office Locations throughout Pittsburgh and southwestern Pennsylvania, Cleveland and northeastern Ohio.