Alternative Pre-Payment Penalty Calculation

Some loan terms in notes calculate pre-payment penalties in terms of compensating the lender for some of or all of the interest that the lender would have earned if the borrower had not paid down the loan. This protects the lender especially when the borrower is locked in a fixed-rate loan and market interest rates drop.

From the borrower's perspective, it is wise to be aware of these loan provisions and how they can affect the cost of capital. If a borrower is convinced that his loan's rate is locked in at a historically low rate and that the market's interest rates will likely rise, then loans with this type of pre-payment penalty will be tolerable. Otherwise, borrowers should consider this type of pre-payment penalty as an additional cost.

Now, let's calculate this alternative pre-payment penalty.

Formula

Step 1:

Unpaid Principal - Yearly Pay-Off Allowance = Total Pre-Payment Principal

Step 2:

Total Pre-Payment Principal x Note Rate = Annual Interest Amount

Step 3:

Annual Interest Amount ÷ 12 months = Monthly Interest Amount

Step 4:

Monthly Interest Amount x Penalty Term = Pre-Payment Penalty

Example

Assume the following loan terms:

Unpaid Principal Balance: $150,000

Yearly Pay-Off Allowance per loan agreement: $20,000

Loan's Note Rate: 6.25%

Pre-payment Penalty Term: 6 months of interest

Calculate the following:

Step 1:

$150,000 - $20,000 = $130,000

Step 2:

$130,000 x 6.25% = $8,125

Step 3:

$8,125 ÷ 12 months = $677.08

Step 4:

$677.08 x 6 months = $4,062.48

Prepayment Penalty = $4,062.48