The Enforceability of Prepayment Premium Provisions

In its decision, the court found that the particular prepayment premium required to be paid in connection with prepayment of a mortgage loan was an unenforceable penalty. The type of prepayment provision at issue in the case is generally referred to as a 'yield maintenance clause,' which compensates the lender for possible lost interest by making the lender whole on a similar investment. The borrower is required to pay the interest spread between the actual loan to be prepaid and a hypothetical alternative investment. In this particular transaction, the yield maintenance provision required discounting the outstanding principal and in-terest which would be due over the term of the original transaction to present value at the reinvestment rate, and the reinvestment rate used was the yield to maturity on a U.S. Treasury bond or note having a similar maturity as the unexpired term of the mortgage loan.

The court's conclusion that the particular prepayment premium was a penalty was based on the disparity between the high credit risk presented in the actual transaction and the lack of credit risk presented by an investment in a Treasury security. The rate negotiated between the parties for the actual mortgage transaction took into account the higher risk of default and impairment to collateral, justifying a premium interest rate. The yield to maturity on U.S. Treasury notes or bonds is virtually risk free (since it is backed by the U.S. government). The court's position was that the reinvestment rate should have been calculated with respect to comparable risk investments, and the court indicated that the parties could still use U.S. Treasury bonds or notes, but would have to include a spread to adjust for the risk differential.