Prepayment Fee: a Worked Example

A lender that has spent months on a loan, and priced it to earn a margin over several years, loses that margin when the loan is repaid early and has to find, assess and document another borrower to put the money back to work. The loss is greatest when the borrower has improved, because a stronger borrower is the one other lenders will refinance more cheaply. The fee shifts part of that cost back to the borrower who chooses to leave.

How much protection a lender asks for depends on how it is funded and paid. A private credit fund earns its return on money deployed and has promised its investors a yield, so it commonly asks for stronger protection in the first years. Many bank business loans at floating rates can be repaid on an interest date with no fee at all, the bank relying instead on break costs where the rate is fixed or the repayment falls inside an interest period, though some bank terms do carry early repayment fees. The facility letter is the only place to find out which applies.

The commonest form is a schedule that falls over time. Market shorthand writes it as prices: 102/101 means 2% of the amount repaid in the first year and 1% in the second. NC1/102/101 puts a year of stronger protection in front, so the 2% applies in the second year and the 1% in the third. A make-whole charges the interest the lender would have earned to the end of a protected period, so that repaying in month two costs most of a year's interest; agreements differ on whether that interest is discounted, usually at a government bond rate, and on whether the next fee is added. A soft call, used in term loan B markets, applies only when the borrower refinances or amends the loan to lower its rate.

What the fee applies to is negotiated as hard as the rate. Many agreements reduce or exclude it for mandatory prepayments from asset sales or insurance proceeds, some allow a small amount to be repaid each year without it, and the treatment of a sale of the business varies.

A family-owned motel group, constructed for this page like every figure in it, borrowed US$9.0m from a private credit fund at an all-in rate of 11.5%, with quarterly interest periods. Its protection, the example's, is a make-whole on any repayment before the first anniversary, counting the interest to that date without discounting and adding the 2% fee that applies from it; then 2% in the second year, 1% in the third and nothing after. At month nine, on an interest date, a bank offers to refinance at 8.1%, saving 3.4 points, or US$306,000 a year. The loan is floating and any refinance would settle on an interest date, so there is no break cost.

Waiting three months saves the group US$182,250 against refinancing now, because the make-whole charges the full 11.5% for months in which the group would also be paying the new lender. Waiting for the cheaper 1% fee costs it more than either, because the saving on the fee is smaller than a year of the higher rate. The fee does not decide whether to refinance. It decides when, and the answer turns on the gap between the two rates as much as on the fee itself. The incoming bank's offer has to stay open long enough for the cheaper date to arrive.

A break cost belongs to a rate the lender has locked in: most often a fixed rate for a term, and under some agreements a floating rate set for the current interest period. When a lender fixes a borrower's rate it usually fixes its own funding too, and an early repayment leaves that funding in place with nothing to earn against it. The charge is a calculation made on the day, from the gap between the fixed rate and what the same money would now earn for the rest of the term, so its size is unknown until the borrower asks. The motel group's 2% was written into the agreement at signing, and the second-year figure would be the same in any market.

The two can apply together. Had the motel loan carried a fixed rate, repaying at month 12 would have cost the 2% fee and any break cost on the fixed funding, and a borrower comparing offers adds both. The payout figure the outgoing lender issues is where the two appear side by side.

DEFINED IN ONE PARAGRAPH → · BREAK COST → · FIXED OR FLOATING →

At signing, the fee is traded against the margin. A borrower that expects to sell the business or refinance within two years has more to gain from removing the fee than from shaving the rate; one that expects to hold the loan to maturity can accept strong protection for a lower margin. The term sheet stage is the time to match the protection to the plan, because a borrower that already needs to leave has little to bargain with.

For the incoming lender, the fee is part of the money needed on settlement day. A refinance that rolls the fee into the new loan starts with debt larger than the debt it replaces, and a credit paper that sizes the new facility on the old balance has missed it. The question for both banks is the same: what will it cost to leave, and when is it cheapest.

REFINANCING AND SWITCHING BANKS → · BANK LOAN VS PRIVATE CREDIT →