Pub. 5 2015 Issue 1

P R EPAYMENT PREMIUMS OR FEES ARE ALSO KNOWN AS YIELD MAINTENANCE PREMIUMS OR MAKE WHOLE PAY- MENTS. ESSENTIALLY THEY ARE CONTRACTUAL CLAUSES THAT COMPENSATE THE LENDER FOR THE loss of interest payments arising from a borrower’s early payment of the loan. It is a form of protection for the lender should the market interest decline below the contract rate. Without such protection a borrower may seek to take advantage of the lower rate by refinancing at current rates. A lender then would be forced to take a loss as it could not reinvest the returned principal at a comparable interest. Ac- cordingly, the prepayment premium is crafted such that the lender is guaranteed its return regardless of the timing of the prepayment or the interest rate at the time of the prepayment. Obviously, these provisions cause consternation to bor- rowers and have spawned state court litigation over whether the clauses are enforceable and reasonable. Generally, under state law, prepayment premiums are enforceable if they are in writing and are triggered by the borrower’s voluntary act of prepaying. In addition, the amount must be reason- ably calculated and related to the actual harm caused to the lender. While there are different formulas or calculations, the method set forth in the agreement will govern. A court will not impose its own methodology to rewrite the agreement. An accepted method for calculating a reasonable forecast of the ultimate damage that might be suffered by the lender is a formula that calculates the prepayment fee based on the net present value of the future cash flow from the loan discounted by a rate equal to the Treasury Bond rate of similar maturity. Prepayment Premiums By CATHY L. REECE and ANTHONY W. AUSTIN 24 www.azbankers.org