Prepayment Penalties and Business Loans

Prepayment penalties are a way for a financial institution to recover income in the event a loan is repaid early and will not continue to pay interest income. Some may feel this is a penalty for successfully attaining a stronger financial standing, and for that reason specifically, I think the NCUA has prohibited prepayment penalties on loans. It seems to go against the spirit of the credit union movement to have members penalized for trying to better their financial position by accelerating repayment.

Generally, I don’t see an issue with the lack of prepayment penalties for consumer loans. However, prepayment penalties can serve a special purpose to discourage early loan repayment when that loan is matched with a funding source of similar maturity.  From a safety and soundness perspective, I fear interest rate risk when long-term assets payoff but long-term funding remains fixed; but this likely has negligible effects in the consumer lending arena.

I think the interest rate risk is more substantial in business lending because of the sheer size of the assets that can reprice instantaneously. To illustrate this point, consider the following example: Say an average car loan is $10,000. Now say the credit union makes 50 car loans which leads to $500,000 in outstanding debt. No doubt, some of those loans will be prepaid by accelerated payments or be refinanced with newer purchases; but it is unlikely all will prepay, and those that do prepay will not all prepay at once.

Now consider making one business loan for $500,000. If the loan is refinanced at a different institution, immediately the entire $500,000 loan fails to provide any interest income to the original institution, and this leaves $500,000 in exposure to funding source of matching maturity. This would have far greater consequences to income and interest rate risk than the example of auto loans prepaying. Without a prepay penalty, the credit union is not penalizing the member for refinancing at a different institution, but this comes at the cost of significant interest rate risk to the credit union’s balance sheet.

I would advocate that the NCUA should allow for prepayment penalties on business loans, because it is critical for the credit union to manage its interest rate risk and other funds management objectives. However, in the spirit of the credit union movement, I think the prepayment should only be permissible if the business loan is refinanced at a different institution. If the loan repayment is accelerated with the member’s own resources, or the loan is refinanced with the same credit union; it would seem fair that a prepayment penalty should not be applied.

Prepayment penalties should not be an ugly concept when they are a tool that helps preserve the strength of the credit union. I would not advocate for prepayment penalties on consumer loans, because the interest rate risk associated with prepayment is more manageable. However, I would advocate prepayment penalties for large business loans that are refinanced at different institutions, because the instant repayment of large assets can seriously affect funds management strategies. By disallowing prepayment penalties on large business loans, members’ deposits are placed at greater risk at the expense of one member benefiting from an easy exit to a different institution.