Prepayment is the early repayment of all or part of a loan. It may be available at the borrower’s discretion, or be required following certain events, and in a properly drafted loan agreement the rules that govern when and how prepayment can or must be made will be set out in detail. Whether prepayment is advantageous to the borrower will depend on the circumstances in which it is invoked.
Mandatory prepayment
Mandatory prepayment arises where specified events occur that oblige the borrower to repay all or part of the outstanding loan. These events, usually set out in the loan agreement, are typically triggered automatically once they occur and are included to protect the lender by ensuring unexpected financial events result in a corresponding reduction in its exposure to the borrower.
Common mandatory prepayment triggers include:
- The sale or disposal of assets, especially those forming part of the lender’s security package
- Insurance proceeds in relation to secured assets
- A material change of control of the borrower
- Illegality
Mandatory prepayments are usually applied without prepayment costs or penalties, although this will ultimately depend on the terms of the loan agreement.
Voluntary prepayment
Voluntary prepayment occurs where the borrower elects to prepay all or part of the loan. This may be commercially attractive where, for example, the borrower wants to reduce interest costs or is refinancing with another lender. There is no automatic right to prepay a loan once made. Although usually included in the loan agreement as an optional right, voluntary prepayment is generally unattractive to lenders because it deprives them of expected interest and exposes them to reinvestment risk, meaning it is typically subject to restrictions on timing and amount and requires the borrower to compensate the lender through prepayment fees and break costs.
Borrower considerations
| Advantages | Disadvantages |
|
|
Borrowers should carefully negotiate and assess prepayment provisions at the outset of any debt financing. Even if a loan agreement allows prepayments, consider also whether any related subordination or intercreditor agreement with any other creditor(s) restricts prepayments and whether that is acceptable. Understanding the financial consequences of both mandatory and voluntary prepayments is important to avoid unexpected costs or restrictions later in the life of the loan when commercially beneficial windfalls may arise.
