Why Prepayment Provisions Matter in Commercial Lending

In an article last week, we discussed why community banks should desire prepayment provisions in their loans. We also acknowledged that in this very competitive banking market banks are unable to negotiate a meaningful prepayment provision. In this blog, we will identify techniques that some banks may use to obtain a meaningful prepayment provision, and we share a video explaining how CenterState Bank lenders use these techniques with commercial borrowers to negotiate a powerful prepayment provision. 

Four Reasons for Prepayment Provisions

In our blog last week we identified four reasons why prepayment provisions increase profitability for banks. The four reasons are as follows:

1)    Decrease the value of the option held by the borrower to prepay the credit.

2)    Increase the lifetime value of the relationship.

3)    Increase cross-sell and upsell opportunities.

4)    Reduce negative selection bias in an economic downturn.

The competitive reality is that lenders and borrowers will heavily negotiate terms, conditions, and pricing for every competitive loan situation. Prepayment provisions are very easy for borrowers to negotiate away for two reasons – first, other competitors are willing to concede them, and, second, the provision is not internally compelling to the borrower. For a lender to successfully negotiate a prepayment provision (or any loan provision for that matter), the lender must convince the borrower that the competition will also insist on a similar provision or (but preferably “and”) that the provision is in the borrower’s interest. We use a prepayment provision at CenterState Bank that establishes both criteria in certain circumstances.

Common Prepayment Provisions

Step-down

By far the most common prepayment provision used by community banks is a step-down prepayment penalty. For example on a 5-year loan, the bank may charge a 3-2-1 or 2-1-1. The borrower pays the number (expressed as a percentage) times the loan amount corresponding to the year of prepayment. The only advantage of this prepayment provision is its simplicity. The disadvantages are substantial. First, because it is hard for a banker to explain why the bank needs the provision for economic reasons, the provision is typically difficult to sell to a borrower. Thus it is diluted (what starts as a 5-4-3-2-1 initial proposal is pushed back to a 3-2-1 or 2-1). Second, enforcing becomes a reputational risk for the bank. While contractually binding, the borrower will complain about paying it, and banks often succumb to waiving it. Third, it is completely disengaged from any market, credit or interest rate movement. 

We were recently negotiating a $9.8 million term loan with a borrower. The negotiations on the prepayment provision went like this:

           Borrower: Why do I need to pay you 5% in the first year (declining to 1% in the fifth year) to prepay the loan? 

           Lender: I can lower that to 3%, 2%, 1% instead.

           Borrower: But why is there any prepayment provision?

           Lender: The bank has costs to underwrite, book and fund the loan. We cannot allow our loans to prepay just because you may find a better deal elsewhere. We have overhead costs for originating loans that are not captured by the 15bps loan origination fee that the bank charges.

           Borrower: Would there be a prepayment provision if the loan were adjustable rate instead of fixed?

           Lender: No, we do not charge prepayment provisions on adjustable rate loans.

           Borrower: Doesn’t the bank have the same underwriting, booking and funding costs for a floating rate loan? 

           Lender: [long pause] I’ll see what I can do.

The lender had to withdraw the prepayment provision because it was not defendable. The borrower could not be convinced that the prepayment provision was in his best interest. Further, we know of only one bank that can obtain a prepayment provision on almost all credits. The charge may be as low as 1% of the loan amount; it only applies if the borrower refinances with another lender and the bank charges no loan origination fees instead of obtaining the prepayment provision. However, most banks cannot retain a step-down prepayment provision in the note, despite their best efforts.

Lock-Out

A lock-out prohibits any prepayment during a specified period. This provision is rare, but we see it utilized in municipal financing, but it is rarely accepted by commercial borrowers. 

Defeasance

This provision is used extensively by insurance companies and conduits. It is extremely disadvantageous to borrowers. The provision is rarely properly explained to borrowers, and we have never seen a borrower presented with a termination scenario before the loan is executed – because the borrower would never signup for the provision if they understood the cost. 

Symmetrical Breakeven

We use this provision for commercial loans at CenterState Bank, and we emphasize first that the loan features and pricing cannot be obtained from any lender without this specific provision, and second, we explain why the provision is in the borrower’s interest.  

This provision trues up or creates a neutral cost/benefit for a prepayment based on interest rate movements. The borrower becomes indifferent, from interest rate movement perspective to prepayment, whether rates are higher or lower. The provision aligns the borrower’s view if that borrower expects rates to rise the borrower collects a fee – an equitable arrangement. Also, the provision is standard for all national and the bigger regional banks that offer long-term fixed rate financing.  The reason that borrowers sign up for the provision is that they accept the fact that the bank has a true cost of loan prepayment if rates are lower, and likewise, the bank has a true benefit of a loan prepayment if rates are higher and the benefit is transferred to the borrower.

But the main reason why we like this prepayment provision is the flexibility it offers the borrower and lender for future financing. The provision makes the loan assignable and assumable. That is a very powerful feature when interest rates are very low but expected to increase over the term of the loan (5, 7, 10 or even 20 year period). The provision can also be modified to create no prepayment windows, partial prepayment windows or prepayment windows based on preset fee amounts.

A powerful aspect of this prepayment provision is the marketing – and especially in today’s interest rate environment. Borrowers who believe that interest rates are heading higher will more likely choose fixed rates over floating rates. Once that choice is made, then the symmetrical prepayment provision allows the borrower to reap a fee upon a loan prepayment if rates do increase as the borrower expects. If the borrower hesitates on this prepayment symmetry, then the borrower is tacitly expressing a view that rates are not heading higher. That makes the borrower a perfect candidate for a floating rate loan, or perhaps short term fixed loan. Either way, the lender can learn the borrower’s view and offer the right product in the right circumstance.

In the link below we recorded a video showing how lenders are selling this provision to borrowers.

Conclusion

In today’s competitive loan market any profit advantage is worth exploring. At community banks, commercial loans are prepaying between 20% to 40% per annum on top of normal amortization (depending on geography, loan category and loan product). The ability to sell the borrower on a prepayment provision can help increase relationship ROE anywhere from 2 to 10%.  

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This commentary on this blog reflects the personal opinions, viewpoints, and analysis of the author and not CenterState Bank. This blog is only intended to provide general education about the banking industry, leadership, risk management, and other related topics and is not intended to provide any specific recommendations. Banks should consult their professionals and fully explore any opportunity and risk referenced herein.

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