DSCR (Debt Service Coverage Ratio) loans are a type of financing often used by real estate investors to purchase investment properties. These loans are based on the property’s projected net operating income rather than the borrower’s credit score or income.
A prepayment penalty is a fee charged by the lender if the borrower pays off the loan before the end of the loan term. Lenders include prepayment penalty clauses in DSCR loans to ensure they receive the interest payments they expected over the full loan term.
This article will explain what prepayment penalties are, why they exist with UK DSCR loans, and things an investor should know about prepayment penalties when getting a DSCR loan.
What is a Prepayment Penalty?
A prepayment penalty is a fee that the lender charges if the borrower repays the loan before the end of the loan term. This early payoff can happen if the borrower refinances the loan or sells the property.
The prepayment penalty is designed to compensate the lender for the loss of expected interest payments over the remaining loan term. Without a prepayment penalty, borrowers could refinance as soon as interest rates drop and stop making payments before the lender recoups the costs of originating and servicing the loan.
Why Do Lenders Include Prepayment Penalties With DSCR Loans?
Lenders include prepayment penalty clauses in DSCR loans for a few key reasons:
To Protect Against Interest Rate Risk
DSCR loans typically have fixed interest rates and terms up to 30 years. If interest rates fall, borrowers have an incentive to refinance and lock in a lower rate. This deprives the lender of the higher interest payments they expected to earn over the life of the loan. Prepayment penalties discourage refinancing by making it expensive to pay off the loan early.
To Recoup Origination Costs
It costs lenders money to originate a new loan through documenting, underwriting, and closing costs. Prepayment penalties help lenders recoup these origination costs in the early years of the loan, when refinancing is most likely.
To Account for Prepayment Risk
Ideally, lenders want loans that fully amortize over the scheduled term. But there is always a risk that loans pay off early. Prepayment penalties account for this risk when the lender prices the interest rate on the loan.
To Prevent Arbitrage
Borrowers could exploit rate differences by refinancing each time rates drop if there is no prepayment penalty. This is called arbitrage, and penalties discourage it.
What are the Typical Prepayment Penalty Structures?
There are a few common prepayment penalty structures used with DSCR loans:
Declining Percentage of Loan Balance
Also called a “5/4/3/2/1 prepayment penalty”, this charges a percentage of the outstanding loan balance as the penalty. It declines each year before disappearing altogether. For example:
- Year 1: 5% of outstanding balance
- Year 2: 4% of outstanding balance
- Year 3: 3% of outstanding balance
- Year 4: 2% of outstanding balance
- Year 5: 1% of outstanding balance
- Years 6+: No prepayment penalty
Declining Number of Months Interest
This penalty equals a set number of months of interest, declining each year. For example:
- Year 1: 6 months interest
- Year 2: 5 months interest
- Year 3: 4 months interest
- Year 4: 3 months interest
- Year 5: 2 months interest
- Year 6: 1 month interest
- Years 7+: No prepayment penalty
Fixed Percentage in Early Years
Some loans have a prepayment penalty that is a fixed percentage (such as 3%) but only for the first 1-3 years of the loan. After that, there is no penalty.
What are the Typical Prepayment Penalty Periods?
Prepayment penalties are usually only in effect for the first 3-5 years of a DSCR loan term. Some common prepayment penalty periods are:
- 3 years – Most prepayment penalties last for the first 3 years of the loan term.
- 5 years – A longer 5 year prepayment penalty period is also common. This better protects the lender.
- 1-2 years – Sometimes there is a very short prepayment penalty period. This offers more flexibility to the borrower.
- Entire loan term – Rarely, a lender may have a prepayment penalty for the full duration of the loan. This provides maximum protection against early payoff.
How Do Prepayment Penalties Impact Exiting an Investment?
For real estate investors using DSCR loans, the potential prepayment penalties influence how and when you may exit the investment:
Selling During Penalty Period
If you sell the property during the prepayment penalty period, the loan will need to be paid off and you will incur the penalty. Factor this into your net proceeds.
Refinancing During Penalty Period
Similarly, if you refinance during the penalty period you will trigger the prepayment penalty. This makes refinancing within the first 3-5 years very expensive.
Waiting Until Penalty Expires
You can avoid penalties by waiting to sell or refinance until after the prepayment penalty period ends. But this reduces flexibility in timing your exit.
Loan Assumption Instead of Payoff
Some lenders allow loan assumptions, where the buyer takes over your existing loan instead of paying it off. This avoids triggering the penalty.
Most lenders grant exceptions to the prepayment penalty for borrower death, disability, or property destruction.
Are Prepayment Penalties Negotiable in UK DSCR Loans?
Ideally, the prepayment penalty would be negotiable based on the specific deal and the investor’s business plan. However, most lenders treat prepayment penalties as a standard term for DSCR loans with little room for negotiation.
But it doesn’t hurt to ask, especially if you have an existing lending relationship or are bringing significant business. Some potential areas to negotiate:
- Shortening the prepayment penalty period
- Reducing the percentage penalties, especially in later years
- Allowing partial prepayments without penalty each year
- Adding exceptions like sale to a family member
While negotiating prepayment penalties can be difficult, it presents an opportunity to potentially customize the loan to your business plan.
Can UK DSCR Loans Have No Prepayment Penalties?
While uncommon, it is possible to find DSCR loans without prepayment penalties. Here are some cases where you may see no prepayment penalties:
Short-term bridge loans are designed to be refinanced, so most do not have prepayment penalties.
Small banks and credit unions financing local deals may offer more flexibility on penalties.
If a lender plans to keep the loan in their portfolio instead of selling it, they may be more open to waiving penalties.
Strong Existing Relationships
Lenders may make exceptions for large or long-standing clients with proven loyalty.
When Rates Rise
In increasing rate environments, lenders have less concern about early prepayments.
The tradeoff is that loans without prepayment penalties typically come with higher interest rates or fees to offset the lender’s risk. So there is no true free lunch.
What Should UK Investors Know About Prepayment Penalties?
For real estate investors considering a DSCR loan, here are some key things to know about prepayment penalties:
- They are a tradeoff for getting lower interest rates.
- Factor them into your exit strategy and timeline.
- Ask the lender detailed questions on the specifics.
- See if you can negotiate concessions if needed for your business plan.
- Model the costs of any early refinance or sale.
- Consider whether you can accept the lack of flexibility.
- Weigh if alternate financing like a bridge loan makes sense for your hold period.
While prepayment penalties limit refinancing flexibility, they allow investors to secure lower fixed rates critical for DSCR loans. Assess if the tradeoff aligns with your investment objectives and risk tolerance.
Prepayment penalties are commonly found in DSCR loans to compensate lenders for the risk of early repayment. Typical prepayment penalties are a declining percentage of the loan balance or number of months interest over a 3-5 year period.
Investors using DSCR loans should analyze the potential impact of prepayment penalties on their ability to refinance or sell the property before the end of the loan term. While negotiating some concession around prepayment penalties may be possible, they are a fairly standard feature of most DSCR loans.
By understanding how prepayment penalties work with DSCR loans, real estate investors can make informed financing decisions aligned with their investment strategy and timeline. Factoring in potential prepayment penalties is key to properly evaluating the true cost of financing.