Prepayments and Extensions. What You Need to Know.
We recently wrote about the importance of deciphering LTVs and using the metric to evaluate loans. Another key piece to assessing loan investments is understanding how loan payments work. Most investors understand the general payment structure of a mortgage; a borrower makes monthly interest payments and principal will either be paid down over time or in a lump sum at the end of the loan term. The nuances in cash flow timing, however, exist when prepayment and extension considerations come into play.
Standard loan documents include provisions for the borrower’s ability to pay off a loan before the specified maturity date (i.e. a prepayment) and whether the borrower has the right to extend a loan at maturity for a set period of time. There are a number of strategic reasons for a borrower to exercise the right to prepay or the right to extend, and investors should understand the implications. If either of these rights is exercised, it will affect the length of time investor money is committed to specific loan investments.
PeerStreet’s Investment Details page outlines what investors need to know about each loan’s prepayment and extension options. The following table is what you can expect to see on every loan investment page:
This particular loan had an initial term of seven months, two 3-month extension options, and was freely prepayable with no prepayment penalty or lock-out period. What does that tell you about the loan? The extension options indicate the borrower could extend the maturity date of the loan, in this case three or six months, past the original maturity date. If the borrower had exercised one or both of the extension options, he would have been obligated to continue paying interest on the loan, but the repayment of principal would have been delayed and, therefore, corresponding repayment of principal to investors would have been delayed as well.
The table above also indicates prepayment penalties and lock-out periods. A prepayment penalty will penalize a borrower for paying off a loan earlier than the stated maturity date and it can come in various forms. To make it simple, a borrower will have to compensate the lender for paying off the loan early and disabling them from collecting future expected interest payments. The sample loan referenced above allows the borrower to prepay the loan at any time without penalty. The lock-out period indicates the time period within which the borrower cannot pay off a loan. Once the loan is out of the lock-out period, a borrower can generally pay off a loan early with no repercussions. The sample loan does not have a lock-out period.
Prepayment penalties and lock-out periods are far more prevalent in loans for commercial real estate than residential real estate. As most homeowners can attest, there is generally plenty of flexibility regarding when a home loan can be paid off.
One of the benefits to PeerStreet’s platform is that even if a loan pays off early, and you miss out on some of the interest that you initially expected to receive, there will likely be several other loan offerings available for you to reinvest those dollars.
Have questions about a specific loan’s payment structure? Contact us at email@example.com. If you do not already have a PeerStreet account, you can get started today at peerstreet.com. It only takes a couple minutes to get set up!