One of the most difficult issues commonly faced by Borrowers seeking to refinance commercial mortgages involves the decision as to when it does, or does not make sense to pay a sometimes substantial prepayment penalty in order to refinance at: 1) a much lower rate, 2) much higher dollars, or 3) both.

Clearly, it’s tantalizing to find yourself in a historically low interest rate environment only to feel shut out of the party because your current loan has a 3% or 4% flat penalty, or, potentially even worse, a yield-maintenance or defeasance prepayment penalty. Yield maintenance or defeasance make the lender indifferent to an early repayment of a loan with a higher-than-current-market interest rate. Briefly, a yield-maintenance or defeasance penalty results in a lender receiving every penny of interest that they would have received holding a loan until maturity. The worst possible scenario, of course is an absolute “lock out” for a certain period of time, which would prevent an early repayment of the current mortgage for any reason whatsoever.

It’s an interesting analysis because, in many cases, there IS no “right” or “wrong” answer…the borrower’s decision is not based solely on mathematics as much as on a Borrower’s immediate need for cash (for repairs, capital improvements, or to pursue other business opportunities), and on a Borrower’s purely subjective assumptions about, and prediction of, the future direction of interest rates.

Still, there are certain situations that are easier than others to grapple with; for example, you’ve got a yield maintenance penalty on a $10,000,000 balloon mortgage, with only three years left to run until maturity. You have no intention of selling the asset, and you fully intend to refinance the debt rather than write a $10,000,000 check to the lender at maturity. You cringe at the prospect of paying a $900,000 prepayment penalty, yet you know that the odds are pretty good that in 3 years, you will find yourself in a higher interest rate environment. So what course of action is better – taking advantage of today’s terrific interest rates, swallowing hard, and at least controlling your own destiny? Or, riding out the current loan, eliminating the penalty and gambling that you won’t get killed by the interest rates that will be available in three years?

I would say that most of the Borrowers that we’ve represented, facing the above dilemma, would pull the trigger and choose the Devil they know over the Devil they don’t know. I certainly would.

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