Real
Estate Finance Notes
Prepayment
Most
courts that consider the issue say that prepayment penalties are part of the
bargain. Since you can lock in the loan
entirely with no prepayment at all, then the lesser measure of prepayment with
a penalty is included. If a promissory
note is silent on prepayment, do you have a right to prepay? There is a common law presumption that the
lender doesn’t have to accept prepayment.
This is the majority rule, but this is a default rule only.
Metropolitan Life Insurance Co. v. Promenade Towers Mutual Housing
Corp.
If
the promissory note says that you’re going to pay over a certain period of
time, that’s what you’re required to do, and you don’t have the right to prepay.
There are a few states that by judicial or legislative action have
reversed the common law presumption, saying that if the promissory note is
silent, you do have the right to
prepay. This is only true in
Lenders
have a number of reasons for prepayment fees and lock-ins. Lenders are concerned about changing interest
rates. The lender wants to maximize the
return on its investment. If interest
rates are going down, it’s in the lender’s interest to keep the mortgage in
existence. It also costs them money to
reinvest or to cover loss from a delay in reinventing. The lender may also have costs of initially
placing the loan that are amortized over the life of the loan. Usually, those costs are covered by “points”:
the interest rate will be, for example 5%, but 1-2% will be charged up-front to
cover these initial costs. If a loan is
locked in or requires an extremely high prepayment fee, does that necessarily
mean that the loan won’t be prepaid? Not
necessarily. The parties can negotiate
out of the original agreement if that’s mutually beneficial.
Let’s
say that interest rates fall and the borrower has the desire to repay a high interest
rate loan and get a lower interest rate loan.
If the present value of the lender’s loss due to repayment is less than
the present value of the borrower’s gain from refinancing, then both parties
will benefit from prepayment at some fee.
However, this situation doesn’t make sense: how can the borrower
refinance for less than the lender is willing to reloan? If that’s the case, then there is no gain
from exchange. So is the prepayment
penalty an unreasonable restraint on alienation? The Restatement argues that it is not because
there is the possibility of bargain. The
prepayment penalty may be attacked as interest if there is a state usury law
that controls. But in most states, such
laws have been greatly watered down. If
the fee is unconscionably high, the courts will reject it. Also, recall that improper liquidation of
damages can be found to be a penalty.
This is judged looking from the perspective of when the contract was
formed and asking whether the parties reasonably estimated their damages. The Bankruptcy Code says that prepayment
penalties will be allowed and will be secured by the mortgage if they are
reasonable.
Should
there be a prepayment penalty when the promissory note contains a due on sale
clause? What if the promissory note is
silent? Is this a question of
interpretation? Is this a default rule
that the parties can contract around, or is this a matter of law? The courts approach this as a matter of
interpretation and divining the parties’ intent. The question is whether it is even a
prepayment. What about cases of fire,
casualty, or eminent domain? The
insurance company pays. You can argue
that in the event of a prepayment, you have to pay the prepayment fee no matter
what. But it’s more controversial to
have the lender say that the borrower can’t rebuild even if they want to.
Fleet Bank of
What
about late fees and “default interest”?
Late fees are seen as liquidated damages. They must be reasonable. They are must more likely to be reasonable if
they are based on the missed payment as opposed to the amount of principal
outstanding. What was wrong with the
late fee in this case? What payment was
late? A balloon payment for the entire
outstanding principal was late.
How
do you discharge the mortgage obligation?
Knowing what you have to do to get out of the obligation is crucial to
being able to enforce it. There is only
one mechanism that can be used to assist with paying off a promissory note. If the obligation is not reducible to
dollars, then you can’t determine how to distribute the proceeds of the
foreclosure sale. You can’t determine
what the mortgagor should do in order to redeem the property from the mortgage. Therefore, the obligation must be measurable
in money.
To
pay $100,000 is a valid mortgage obligation.
That’s an ordinary mortgage obligation.
But a promissory note can secure a promise to construct a house. As long as you can tell with some amount of
certainty what the house is worth and when it’s supposed to be built, it’s okay. Note that
there is a different standard depending on who you are
enforcing the mortgage against. If you
are enforcing against a third party, there will be a greater degree of
certainty as to what the obligation is than when you’re talking about the understanding
between the original two parties. The mortgage
obligation could be to obtain rezoning of land.
What about the purported obligation to support the mortgagee for life? Uh…I forgot.
Merger
The
purpose of this doctrine is to simplify title.
If someone has a life estate and a remainder, they basically have the
whole bundle of sticks, and we just say that they have the fee simple. That’s what the law does. The merger doctrine does not work to modify
any substantive rights, but sometimes courts use it this way. If the mortgagor and mortgagee become the same person, for example when the mortgagee
buys the property at foreclosure, we might say that the mortgage is gone and
the former mortgagee holds a fee simple.
But keep in mind the purpose of the doctrine. Sometimes when we say the mortgage is
extinguished, we modify the substantive rights of the parties.