DSCR prepayment penalties and exit math for LA and IE rentals

Why investor loans carry them

A lender prices a loan assuming it will be repaid over a period. When a borrower pays it off early, the lender loses the remaining interest it expected and has to redeploy the money. A prepayment charge compensates for that, and lenders typically price a loan with a longer prepayment period more favorably than one with no charge.

That trade is not inherently bad. An investor who plans to hold for the full prepayment period gets the benefit of the lower rate without paying the charge. The problem is an investor who takes the lower rate and then sells in year two, having never priced the exit.

The common structures

The most common structure is a declining (step-down) charge: a defined share of the amount being prepaid in year one, stepping down each year until it reaches zero. Most programs apply it to the balance being paid off, but some note language measures it differently, so read how your note defines the base before you assume the charge shrinks as you pay down principal.

Yield maintenance works differently. The charge is calculated to make the lender whole for the interest it would have earned, usually by comparing the loan’s rate to a reference rate at payoff. In a falling-rate environment, that charge can be larger than a declining structure would produce.

• Length of the penalty period and the schedule of step-downs
• Whether the charge is measured on the original balance or the amount prepaid
• Whether a sale and a refinance are treated the same way
• Whether partial principal payments are permitted without charge
• Whether the lender offers a waiver on its own refinance

Calculating the exit cost

Take the loan amount, find the charge that applies in the year you expect to exit, and multiply. Then add the costs of the exit itself: the payoff statement fees, the new lender’s costs if you are refinancing, and the transaction costs of a sale. The sum is what leaving costs.

Compare that sum to the monthly difference between the loans you are choosing between, multiplied by the months you expect to hold. A loan that saves a small amount each month and costs a large amount to leave is a worse loan for a short hold, and a better one for a long hold.

Ask for the payoff estimate in writing at the month you expect to exit.

The sale scenario

A sale is the exit most investors plan for and the one they price least often. If the property is sold in year three and the loan carries a charge in year three, the charge comes out of the proceeds. On a property that has appreciated, that may be acceptable; on a property sold for liquidity, it can turn a neutral outcome into a loss.

In Los Angeles, where the Measure ULA transfer tax also applies to higher-value sales, the exit has more than one line item. The prepayment charge and the transfer tax are both worth knowing before you sign, because together they change what your exit actually costs.

The refinance scenario

Refinancing into better pricing is the most common reason investors prepay, and it is exactly the scenario where the charge can erase the benefit. If the monthly saving is modest and the charge is large, the refinance may not pay for itself within the holding period you actually expect.

There is one partial remedy worth asking about: some lenders waive or reduce the charge when the borrower refinances with the same lender. Ask before you close, not after.

How to choose

Decide how long you intend to hold, and be honest about it. Then price both loans over that holding period, with the exit charge included. If the difference is small, take the structure that leaves you more freedom. If the difference is large enough to justify the constraint, take the constraint knowingly.

What you should not do is choose on the note rate alone and discover the exit cost when you sell. The prepayment section is short, usually near the end of the term sheet, and it can decide whether a good loan was a good decision.