Last edited: May 1, 2024
What is a Prepayment Penalty?
If you are a rental property investor shopping for a DSCR loan, you have probably come across the concept of a prepayment penalty. A pre payment penalty is a fee charged to the borrower for paying off the loan during a specified period of time.
Why do lenders charge a prepayment penalty?
Private lenders charge a pre-payment penalty to avoid a scenario where a loan is originated and then quickly paid off through a refinance or sale. In exchange for a competitive interest rate, the lender is looking to secure a longer duration of interest payments.
Let's take a moment to review common pre-payment penalty options and share insights to help you choose the best option for your next financing.
Do lenders charge a prepayment penalty for fix and flip loans?
You should not be charged a prepayment penalty for short term interest only loans (i.e. fix and flip, bridge, construction, hard money). Some lenders charge a 1% fee on the back end of the loan which we think is a cheap shot "junk fee". If you have a 12 month term on a fix and flip loan, and you're out of the loan by month 6, via sale or refinance, then you should not have to pay any additional penalty or interest. You should only pay interest for the time you held the loan.
5-4-3-2-1 Prepayment Penalty
A 5-4-3-2-1 prepayment penalty, otherwise known as a 5 year stepdown prepayment penalty, charges a 5% fee on the outstanding principal loan balance if the loan is paid off in year 1, a 4% fee in year 2, a 3% fee in year 3, a 2% fee in year 4, and a 1% fee in year 5. If the loan is paid off in year 6, there will be no prepayment penalty.
The 5-4-3-2-1 prepayment penalty option carries a slightly lower interest rate than other pre payment penalty options, typically by 0.15% compared to the 3-2-1 prepayment penalty option, and is particularly popular among buy and hold rental investors during times of low interest rates.
3-2-1 Prepayment Penalty
A 3-2-1 prepayment penalty, otherwise known as a 3 year stepdown prepayment penalty, charges a 3% fee on the outstanding principal loan balance if the loan is paid off in year 1, a 2% fee in year 2, and a 1% fee in year 3. If the loan is paid off in year 4, there will be no prepayment penalty.
The 3-2-1 prepayment penalty option carries a slightly higher interest rate than the 5-4-3-2-1 option, typically 0.15%, and is particularly popular during times of elevated interest rates, because the borrower will be able to cost effectively refi after only a few years. The 3-2-1 pre payment penalty is the most popular option among clients of OfferMarket Capital.
2-1 Prepayment Penalty
A 2-1 prepayment penalty is a carries a slightly higher interest rate than the 3-2-1 prepayment penalty, typically 0.125%.
3-0 Prepayment Penalty
A 3-0 prepayment penalty, charges a 3% fee on the outstanding principal loan balance if the loan is paid off in year 1, and no prepayment penalty thereafter. The 3-0-0 prepayment penalty option carries a higher interest rate than the 5-4-3-2-1 option, typically 0.4%, and is worth considering if you want to have a cost effective option to sell or refinance after the first year.
1-0 Prepayment Penalty
A 1-0-0 prepayment penalty, charges a low 1% fee on the outstanding principal loan balance if the loan is paid off in year 1, and no prepayment penalty thereafter. The 1-0-0 prepayment penalty option carries the highest interest rate compared to the 5-4-3-2-1 option, typically 0.65%. Like the 3-0-0 option, this is only worth considering if you expect to sell or refinance the property soon after the loan is originated. Many private lenders will require loan committee approval to offer this option, since the borrower may be trying to use this option instead of a short term bridge loan which typically carries a considerably higher interest rate.
No Prepayment Penalty DSCR Loan
Some DSCR lenders, including OfferMarket, offer a no prepayment penalty option. It is also important to note that certain states such as Pennsylvania and Ohio do not allow prepayment penalty for loans below a certain amount. In cases where there is no prepayment penalty, you can either expect a higher interest rate, or an upfront lender fee charged on the settlement statement.
In our core DSCR loan, in states that do allow prepayment penalty, the interest rate for no prepayment penalty is the same as the 5-4-3-2-1, however there will be a 1.125% lender fee added to the settlement statement. In scenarios where the state does not allow a prepayment penalty, we are able to offer a slightly higher interest rate (~0.25%) and/or a low additional lender fee typically not higher than 0.625% of the loan amount.
Extra payments on DSCR Loan
Many borrowers do not realize that partial prepayment of principal during the prepayment penalty period are subjected to a penalty fee. So, if you have a 5-4-3-2-1 prepayment penalty clause, and you make a $1,000 additional payment towards your principal loan balance during year 1, you will be charged a 5% fee of $50.
Prepayment Penalty for Fix and Flip Loan
While pre payment penalties are a standard term for DSCR loans, they are not common for short term fix and flip loans.
Instant DSCR Loan Quote and Pre-Approval
Our friendly and knowledgeable relationship managers are always happy to review loan requests and help you select the best pre payment penalty option for your real estate investing goals. For instant DSCR loan quotes and pre-approval, visit OfferMarket Capital.
