Mortgage Prepayment Privileges
For many years mortgages in Canada have been structured to be partially amortizing. This was a result of lenders being permitted to reduce the terms of their mortgage loans. Rates no longer had to be fixed for the duration (often 25 years) of the loan. Not surprisingly this lead to a rapid increase in the availability of residential mortgages. Lender debt could be re-priced upon loan maturity.
Residential mortgagors have further rights, pursuant to Section 10(1) of the Interest Act, namely to prepay their loan, after 5 years, upon payment of an additional 3 month interest penalty. This enabled consumers to negotiate longer term mortgages, without the risk of incurring excessive lender penalties. The reality however, is that the overwhelming majority of residential mortgages in Canada are structured for 5 years or less, thus do not fall under Section 10.
Commercial Mortgages are typically closed
Overwhelmingly, commercial mortgages are granted to borrowers who tend not to be individuals, but rather tend to be commercial enterprises of some description. Section 10 Interest Act privileges do not apply to a corporation, or joint stock company, nor since 2012 do they apply to Partnerships. These loans are typically referred to as being closed for the duration of the term. Repayment must be made upon the contractual terms of the mortgage, until its maturity date.
What Prepayment Rights do Commercial Mortgagors have?
On the presumption that mortgages to commercial enterprises are consequently “closed” for the duration of the term of the loan, what right or ability does a borrower have to prepay a loan? For the most part, no such prepayment privilege exists.
Why? In simple terms, the lender, in granting the mortgage, is relying on the receipt of a predictable stream of cash flows over the duration of the loan term. This cash flow is providing a rate of interest, or spread, over that rate paid to the lender’s depositors, on a savings product with a similar term. In lender terminology, the oversight of these cash inflows and outflows is known as ALM, or Asset Liability Management. Any unforeseen disruption to a regular and predictable cash flow immediately impacts the lender’s interest income, often to their detriment. No surprise, as borrowers tend to repay higher rate loans, not below market rate debt!
What Alternative might a Mortgagor Have?
Is there an alternative available to a commercial mortgage borrower in these circumstances? Yes, there typically is. Many lenders will negotiate a prepayment privilege in favour of a borrower. Prepayment will be determined differently from lender to lender, however the basic premise remains common. The lender will seek to maintain their anticipated yield, hence the common usage of the term Yield Maintenance Penalty.
What is the basis of the penalty determination? It is rooted in the logic that the lender wishes to earn an amount of interest which would have been earned had the request for borrower prepayment not been made. Some lenders may simply indicate that prepayment will be accepted on a “yield maintenance” basis. Others lenders may stipulate a formula. This is often the sum of the present value of the anticipated remaining payments and maturity balance, had the prepayment not been requested. This is discounted at a rate comparable to that rate which would be charged today for a mortgage investment of comparable quality, for the remaining term.
The Challenge for the Borrower
A lender cannot be sure that a comparable quality mortgage is available for them to put those prepaid mortgage funds back to work. The position of the lender may be to use a discount rate lower than current mortgage rates. This results in a higher prepayment penalty. The rationale for such a decision is straightforward. If a comparable quality mortgage is not available, in theory a Government of Canada bond most certainly is. The use of a bond yield rate will undoubtedly add to the prepayment costs. Knowing how your lender will treat a possible prepayment request is an important consideration in your initial mortgage negotiations. Be informed!