Rethinking Commercial Prepayment Penalties

I see very few prepayment penalties on commercial and agricultural loans throughout credit unions.  Part of this is from the NCUA regulations, which prohibit federally chartered credit unions (FCUs) in the majority of the cases to charge them to clients, or if they are charged, they must be forgiven.  I think the idea is prevalent in our industry that a prepayment penalty hurts the member and therefore, we do not want to do that.  But have you considered how the lack of a commercial prepayment penalty hurts the credit union?

Whenever you make a loan and lock in the interest rate, unless you just have some unlimited source of free capital or do not care, you should be concerned with the cost of your funding to make that loan.  In many banks I worked at, we used some index such as the US Treasury Curve or LIBOR Swap Curve to understand what the underlying cost of those funds were, for say, a three year locked rate, if we had to go into the market and borrow those funds.  That would provide us with a base cost of funding for the loan with a three year fixed rate. 

A prepayment penalty came in as an asset-liability management tool to help keep the assets we put on the books in place for the duration we expected them to be there, before we would see the loan re-price.  I would contend that the current regulation restriction on prepayments hinders the Federally chartered credit union from using the best practices in the industry in regards to balance sheet management.  The challenge here is that all the large loans booked are at risk of leaving.  This is especially true when rates are higher, and we begin to see a decrease in interest rates.  Everyone is ready to refinance from their higher rate loans.  Prepayment penalties help those loans stay on the books.

It is also interesting to note that other funding sources like banks, insurance companies, and conduits all use prepayment penalties to manage their balance sheets.  While the lack of a prepay may make you more customer friendly, it does have the potential of hurting the financial stability and earnings potential of your credit union.

So should every commercial or agricultural loan have a prepayment penalty?  No.  I can think of several cases when, for a business reason, you would not want a prepayment, or you would want to waive a prepayment.  Some examples of these would be church loans, a problem loan that you need to get out of, or a loan that has an interest rate below the market rate you could replace that loan with.  There will also be cases when you want to have a prepayment penalty but will allow the borrower to pay off an additional amount of principal, say no more than 5 or 10% of the loan amount. 

There are provisions allowed in the regulations for an FCU to charge a prepayment.  This is outlined in §701.21(e), which allows for prepayments for a business loan that is made under a government insured or guaranteed loan program, where said program allows for a prepayment penalty.  An example of this would be the SBA subsidy recoupment fee or prepayment penalty, which is part of the 7(a) program.  Another example would be on a guaranteed FSA loan that allows for a prepayment penalty.

This is also outlined in a letter dated May 20, 2004 from Sheila Albin, Associate General Counsel to James Hammersley, Director of the U.S. Small Business Administration.  Other regulations that apply here are 12 U.S.C. §1757(5)(A)(m) and (viii), 12 C.F.R. §§701.21(c)(6) and (e), and 723.4.

So to conclude here, if a prepayment penalty is allowed, it is wise to charge it.  For now, on commercial loans that are owned by an FCU that do not have a government guarantee, no prepayment may be charged.  State Chartered Credit Unions may charge a prepayment.  But if any portion of that loan is participated out to an FCU, it would need to be refunded.