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Commercial Mortgage Math

Detailed example on how a commercial mortgage broker works to develop the best financing strategy for your business.

When interest rates are low commercial mortgage borrowers begin to think about whether it makes sense to prepay their current mortgages. Given the fact that all fixed-rate commercial mortgages have some form of prepayment penalty, it is important to calculate the penalty versus the potential savings. Ultimately, the cost-benefit analysis will come down to the following question: at what point into my new loan will I recoup my cost of prepaying my old loan?

If you are looking to simply reduce your interest rate. it is only prudent to start this analysis based on your new rate being at least one percent lower than your current rate unless your current loan is at or near maturity. Generally speaking, if your new loan is for ten years and you can make up the costs of the prepayment in less than four years, you are realizing the benefit of prepayment in the last six years. This decision- making process is best represented by example.

  • Example 1
    Suppose you have a $2,000,000 mortgage with a rate of 8.5 percent and a 5 percent prepayment penalty. Your current annual debt service is $184,500 based on a 30-year amortization schedule. Say your new rate is 7 percent with a 30-year amortization schedule and the new loan amount is $2,150,000 to cover the cost of the $100,000 prepayment penalty plus additional closing costs. Your new debt service would be $171,650, thus saving you $12,850 per annum. Dividing the $100,000 prepayment penalty by the $12,850 of annual savings would yield a break-even of almost eight years. Thus it does not make sense to prepay in this example.
It does, however, become more complicated when the co-op has only one or two years left until its loan will reach the end of term. In this case, the borrower will be forced back into the market within a short period of time leading to the question of “Is today’s rate environment better than tomorrow’s?”

Of course, no one can predict what future rates will be, but if the interest rate in two years is ten percent, the borrower will be looking back having wished they had taken advantage of today’s lower rate.

  • Example 2
    Using the above parameters from Example 1, your current loan is $2,000,000 with a rate of 8.5 percent and annual debt service of $184,500. Your prepayment penalty is, instead, 3 percent. If you prepaid, your new loan would be $2,100,000 (inclusive of paying for the $60,000 prepayment penalty) with a rate of 7%. Your new annual debt service is $167,650 which represents savings of roughly $16,850 per year. Thus, the $60,000 prepayment penalty is essentially recovered in 3.5 years. Thus it probably makes sense to prepay in this scenario. Again, if the loan is maturing soon, the risk of future interest increases should serve as additional motivation.

Mortgage brokers can assist clients in this decision-making process. It is clearly not black and white, particularly when you are trying to anticipate where interest rates may or may not be. It is very difficult for professionals and even harder for laymen to anticipate future risks. You can be sure that hindsight is 20/20 especially when looking back at your prepayment decision.