How Does a Hard Money Loan Prepayment Penalty Work?

If you’re new to hard money lending, it’s good to know how the prepayment penalty works, which can be different than with traditional financing like bank loans or NonQM loans. This blog post will explain the difference between traditional prepayment penalties and the two hard money loan prepayment penalty types that you're most likely to see on a bridge loan and longer-term loan. 

Below are the topics I'll cover:  

  • Traditional Prepayment Penalty
  • Hard Money Guaranteed Interest
  • Sliding Scale Prepayment Penalty

Traditional Prepayment Penalty

Most conventional loans, like bank loans or NonQM loans, have a prepayment penalty over the first 1-5 years calculated at 80% of six months of interest.

For example, on a $500,000 conventional loan at 5.00% interest-only, the monthly payment would be $2,083/mo. If the loan had a 36-month prepayment penalty, which means that if the loan was paid off during the first 36 months, the borrower would be required to pay a penalty of $10,000.

$2,083/mo x 6 months = $12,500 x 80% = $10,000

If the loan was paid off at month 34, with only two months left before the prepayment penalty was to expire, the prepayment penalty would still be $10,000. Traditional loans don’t prorate the prepayment penalty if a borrower pays off the loan right before the penalty period expires.

Hard Money Guaranteed Interest

In hard money lending, where most loans are short-term bridge loans of 6-24 months, lenders and trust deed investors typically use a guaranteed interest clause rather than a traditional prepayment penalty. A 3-month interest guarantee means that the lender requires at least three interest-only payments on the loan. Lenders want to get at least a few months of yield prior to getting paid off, therefore, they’ll include a guaranteed interest clause.

If a $500,000 hard money bridge loan at 10.00% interest-only ($4,166/mo) with a 3-month interest guarantee is paid off after the second payment, the payoff demand would include the principal balance plus the third month interest payment.

Payoff after 2 payments: $500,000 + $4,166.67 (month 3) = $504,166.67  

Below is an example of how the prepayment penalty reads in the Note:

Prepayment Premium Guaranteed Interest

As you can see from the example above, the prepayment premium, or guaranteed interest period, expires on October 1, 2022.

“After the prepayment premium has elapsed, Borrower may prepay this Note in whole or in part at any time without paying a premium.”

Sliding Scale Prepayment Penalty

Some hard money loans are written for 5-15 years, which can have a sliding scale prepayment penalty over the course of the first 2-5 years. I’ve originated several 15-year hard money loans with a 5-year 5,4,3,2,1 sliding scale prepayment penalty, starting off at 5% of the loan balance in Year 1 and ending with 1% of the loan balance if paid off during Year 5 with no penalty in Years 6-15:

Sliding Scale PPP

Lenders requiring a sliding scale prepayment penalty can negotiate the terms any which way. If a borrower takes out a 15-year loan but expects to pay off the loan within 3 years, the lender may set different terms of the prepayment penalty, where it’s 5% of the loan balance in years 1-2 and 4% if paid off in the third year:

Sliding Scale PPP 3 years

Conclusion

Hard money prepayment penalties are different than the prepayment penalties of bank and conventional loans, where they are usually 80% of six months interest for a certain period. Short-term hard money bridge loans often use a guaranteed interest clause where the lender may want three payments to be made as prepayment premium, after which the balance can be paid in full without penalty. For longer term hard money loans, sliding scale prepayment penalties are what you’re most likely to see when financing an investment property for 5-15 years.