Pre-Payment Penalty Rates Can Be High

The last two articles discussed pre-payment penalties in loan transactions.  A “pre-payment penalty” is a penalty, or a charge, assessed against a borrower by a lender for the privilege of paying off a loan early.  Unless a lender agrees or unless a statute applies, lenders in California aren’t obligated to accept early payoff on a loan. Instead, in some cases a lender can charge a penalty to a borrower who wants to pay their loan off early.  Such a penalty is commonly known as a “pre-payment penalty.”

The effect of a pre-payment penalty loan provision can be significant. In one case, a borrower purchased a small ranch on 20 acres of land.  The Seller agreed to finance the sale by taking back a promissory note from the buyer.  The contract provided that the Buyer would only make limited payments to the Seller during the first five years after the sale.  The Seller wanted to stretch the payments out over several years because the Seller’s tax payments would be considerably smaller than if the purchase price were all paid at once.  The loan documents   provided that if the Buyer paid off the loan early, then the Buyer would pay the Seller a significant pre-payment penalty.

Several months after buying the ranch, the Buyers filed suit against the Seller and sought to invalidate the pre-payment penalty portion of the loan documents.  The Buyers wanted to build a new home on the ranch, and they needed to pay off the loan from the Seller in order to get a new loan to finance the construction of their new home.

The Buyers claimed that the pre-payment penalty was so high that it was unreasonable.  The Seller demonstrated to the court that if the Buyer paid the loan off early, the Seller would suffer severe negative tax consequences.

The Court reviewed the applicable law, and noted that several code sections provide Borrowers with pre-payment penalty protections for residential property.  But apparently because this property was primarily a ranch instead of a residence, the court didn’t apply the protections available to residential homeowners.  Instead, the Court upheld the pre-payment penalty amount provided in the loan documents.

The amount of the pre-payment penalty?  Fifty percent.  This means that the lender could legally charge and collect from the Borrower a penalty of fifty percent on all prepaid amounts as provided by the loan documents.

A fifty percent increase in the amount needed to payoff a loan is significant.  A fifty percent penalty on early loan payment would usually seriously alter the attractiveness of a loan. Not all pre-payment penalty rates are as high as fifty percent.  But in the appropriate circumstance, a pre-payment penalty of even fifty percent can be legal.

Pre-payment penalties, like many loan terms, are complex and are governed by several different statutes. Loan terms and documents can be complex and may be unfavorable or misleading.  Persons interested in signing loan documents and borrowing money do well when they consult competent legal counsel.

Copyright 2023 ROBERT B. JACOBS