The other day a young lawyer in my firm asked: “Does the client want a prepayment penalty in the loan agreement?”
I made him stand the corner and repeat, “There are no prepayment penalties. There are no prepayment penalties.” Over and over.
The law, the maxim goes, abhors a penalty. So, if you’re a lender, please don’t call it that. It’s a “fee, it’s a “premium,”, but it’s never, NEVER, a “penalty.” It is a sum of money that is designed to compensate the lender when the fixed obligation return represented by the loan is interrupted by the early payment. In the absence of a prepayment fee, when the loan is paid off early, the lender not only loses the interest that would have been earned had the loan matured naturally, but now the bank has to redeploy those funds, find another credit-worthy borrower, and underwrite and document a new loan, just to get the return that it anticipated from the loan that has now gone away. What cold heart would think this loss to the bank should not be covered where the borrower repays the loan earlier than agreed?
The prepayment fee should, therefore, be reasonably related to the loss the lender incurs, usually indexed to U.S. Treasury obligations or the LIBOR, for a fixed period of time, to cover the lender’s loss of interest income for a period of time, and for the out-of-pocket costs of employing the funds elsewhere. Remember, if the fee is excessive, then a court may conclude that it’s actually a penalty and strike it down, even though you listened to me and called it a “fee.”
This post was written by attorney Rick L. Knuth