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Why Does the Lender Want Prepayment Penalties

In a nutshell, it costs money to lend money. Generally speaking, the transactional costs by a bank to lend money on a loan are covered through the spread of interest rate over the life of the loan minus their cost of money at the time of loan origination. 

In a very, very low interest rate environment like the one we’re currently experiencing, lenders experience rate compression, whereby the pressures from what depositor’s demand and what the market will bear for interest on loans makes it challenging to cover their costs.  

Let’s say you get a five-year loan on an aircraft. Then just a couple of years later, you turn around and pay it off early. Good for you, right? Well what’s good for you might be bad for the bank. If the bank originally lent you money when the market was 5% on loans and now the market is 4%, the bank has to redeploy the money at lower net interest margin. As a result, your early payoff would significantly eat into or completely decimate the bank’s ability to cover the loan’s administrative overhead. This is particularly true when rates are dropping. By adding a prepayment penalty, it guarantees the bank a non-interest, revenue source from which to cover the sunk transactional costs (as well as redeployment of funds) associated with that loan.

We’re often asked, “Can I get a loan without a prepayment penalty on it?” Yes, sometimes. The most important two conditions lenders consider for removal of prepayment penalties from a loan package are these: if the rate is floating; or if the lender is sufficiently comfortable that they won’t have this pay off and have to replace it with a less profitable loan.

Remember that in cases where negotiating out the prepayment penalty is possible; the lender’s costs still need to be covered.  The burden of potentially shared out-of-pockets will be shifted to you completely. Out-of-pocket expenses typically include appraisal, titling, settlement and other legal document paperwork associated with closing. In other words, there is no free lunch. Knowing the likelihood of whether you’ll pay off early is an important factor you should consider. It’s often times worth it to pony up the closing costs up front vs. say paying a one or two percent prepayment penalty.

Also, in most circumstances, if you’re thinking about buying another airplane in the short term, prepayment penalties can be frequently negotiated away as long as you stay with the existing lender on a new loan of greater or equal amount.

One major caveat. If you think you’re only going to hold the loan for 3-6 months, a year max before repaying it, an aircraft loan may not be the best option for you. The expense and time invested in the aircraft loan process--because they’re digging into the aircraft plus your personal and business financials potentially, make it inefficient in the short term. You may instead consider bridge financing.

There may be some less expensive and more efficient alternatives to consider, including taking a margin loan on your marketable securities or a a line of credit through your business or a HELOC. All of these could potentially be more efficient than investing 2-4 weeks on waiting for the plane and you to be vetted before a lender will grant you an airplane loan. 

To better understand your options and review your specific situation, give us a call we’re here to help our members.

Great rates. Great terms. Helpful and responsive reps. Three good reasons to turn to AOPA Aviation Finance when you are buying an airplane. If you need a dependable source of financing with people who are on your side, just call 800.62.PLANE (800.627.5263) or click here to request a quote.
Adam Meredith

Adam Meredith

President of AOPA Aviation Finance Company
Adam Meredith, President of AOPA Aviation Finance Company, is an aircraft finance professional with more than 15 years lending, small business management and customer service experience. Adam is a commercial pilot with multi-engine and instrument ratings.
Topics: AOPA Aviation Finance Company, AOPA Products and Services, Ownership

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