By Brent Pritchard

It may take two to tango, but it’s only going to take one borrower or mortgage banker (who forgets what life was like before receiving the lender’s money) to get fired up from this one.

Here’s an excerpt from my book Would Your Boomerang Return? What Birds, Hurdlers, and Boomerangs Can Teach Us About the Time Value of Money (2023):

All investors are focused on yield, whether or not investment yield takes the form of interest. For proof of this, we need look no further than loan documents and a provision that is commonly included and titled “Yield Maintenance.” It’s not called “Interest Maintenance,” even though interest is the form most, if not all, of the yield takes for the loan.

A mortgage lender may require that a borrower pay yield maintenance (aka a prepayment premium) if the loan is prepaid early to compensate the lender for the loss of the bargained-for yield. Again, not “bargained-for interest.”

And for the record, it’s not a “prepayment penalty.” One of many lessons real estate attorneys have taught me is that one can only get what another has to give. A lender gives a borrower the right to prepay the mortgage loan, and as a result, the borrower gets the flexibility that comes with holding an option.

Investors pay a premium for an option. In the case of a CML, the borrower controls whether to exercise the option and thereby prepay the loan. The agreement is governed by the loan documents that describe this right, among others, and create the bargained-for deal. Some people like to refer to the lender–borrower relationship as a “two-way street,” but I prefer the roundabout visual. It’s not the initial give and get that defines the relationship as much as it is the agreement that the getter will give and the giver will get. That’s what makes it come full circle. In the example, the getter received a right or option—but don’t stop short, there’s more—based on what was bargained-for. If the option is exercised, the only thing the getter can give is what was received, which is the bargained-for right to pay the required prepayment premium.

Still not convinced the correct term is prepayment premium? Are you a borrower?! If you still insist on calling it a “penalty” then know that it’s a penalty from the lender’s perspective. I know the argument: “But our profit from the sale of the real estate will be reduced to the extent of the prepayment premium.” That’s right, it will. And that’s why a holder of a traditional put option is willing to pay a premium that just might cut into their profit. Given the zero-sum nature of options, when the right is exercised one investor’s premium will result in another’s penalty.

Why would you break a (promissory note) promise and not call it what it is: a prepayment premium?

Brent Pritchard is an author and college finance lecturer with over two decades of industry experience and cofounder of Boxholm Press, LLC, a family-owned-and-operated publishing company providing educational content, products, and services. He pioneers an innovative and approachable new way of learning and teaching the Time Value of Money as well as thought leadership in other business topics. His most recent book is Would Your Boomerang Return? You can contact him on his website here.