Lenders face heightened compliance risk as states vary widely.

In today’s shifting legal environment, lenders must stay alert to state-specific prepayment penalties (PPP) that may affect their underwriting decisions, especially in loans to LLCs or for business purposes.

Some states, like New Jersey, present challenges due to its statutory ambiguity regarding LLCs. Others, including California, Florida, and Texas, provide clearer rules. States such as New York and Illinois provide protections for residential borrowers but allow more flexibility for business-purpose loans.

New Jersey’s Ambiguity on LLC Borrowers

New Jersey law protects certain borrowers from PPP on mortgage loans. Under N.J.S.A. 46:10B-2, a mortgage loan may be prepaid “by or on behalf of a mortgagor at any time without penalty.” A “mortgagor” is defined as “[a]ny person other than a corporation liable for the payment of a mortgage loan, and the owner of the real property which secures the payment of a mortgage loan.” (emphasis added).

The statute further defines a “mortgage loan” as a loan secured by real property with one to six dwelling units, where the interest rate exceeds 6% annually. The property may be used for nonresidential purposes, provided a residential component is present and the loan proceeds are used for construction or improvement of the dwelling. Although the definition explicitly excludes corporations, the statute is silent on LLCs. This lack of clarity has created uncertainty as to whether LLCs are considered “mortgagors” under the statute. Despite this ambiguity, many lenders continue to apply PPPs to loans made to LLCs—exposing themselves to different interpretations and potential litigation.

To date, no published New Jersey case law has directly addressed whether an LLC qualifies as a “mortgagor” under N.J.S.A. 46:10B-2. In Lopresti v. Wells Fargo Bank, 435 N.J. Super. 311 (App. Div. 2014), the court held that a loan made for business purposes did not qualify as a “mortgage loan” under the statute, even though it was secured by a guarantor’s personal residence, because the proceeds were used solely for business purposes. While informative, this case did not address the status of LLCs under the statute.

Recently, Fortra became aware that a servicer sent a memo to its customers citing an unpublished New Jersey Department of Banking and Insurance Opinion (DOBI) opinion (No. 0081), which suggests that LLCs are not categorized as corporations under the statute. However, because the opinion is not publicly available, Fortra has not been able to verify this conclusion. Fortra has inquired with the DOBI, but at the time of this writing, DOBI has not confirmed the opinion.

Fortra Law is actively seeking clarification on this issue, including any legislative amendments, regulatory guidance, or case law that may clarify the treatment of LLC borrowers under N.J.S.A. 46:10B-2. Given the current uncertainty, we recommend lenders consult with counsel when structuring New Jersey loans involving LLCs and one-to-six dwelling unit residential properties.

A Look at Other States

While New Jersey remains ambiguous, many other states provide clearer guidance related to PPPs for business-purpose loans to LLCs. State regulations vary depending on the state’s stance on consumer protections and business lending practices.

California. California enforces strict limits on prepayment penalties for both residential and commercial loans. Under California Civil Code Section 2954.10, prepayment penalties are generally prohibited for loans secured by residential properties, unless the loan is classified as a business-purpose loan. Even then, PPP restrictions vary based on the lender’s or broker’s license, the property type, the loan type, whether the interest rate is fixed or adjustable, and the term of the loan. In some cases, the penalty must not exceed a specified percentage of the loan amount, and in all cases, the PPP must be clearly disclosed to the borrower at the time of loan origination. Regarding loans to LLCs, California law tends to focus on whether the loan is for a business or residential purpose, in addition to whether it complies with the other regulatory protection standards.

Florida. Florida’s law regarding prepayment penalties on business-purpose loans is a bit more lenient. In Section 687.04 of the Florida statutes, prepayment penalties are generally permissible for commercial loans, but they must be explicitly disclosed and not excessive. However, Florida law places certain restrictions on residential loans, and prepayment penalties may be limited depending on the amount of the loan and its classification. Florida’s commercial loan designation typically includes loans made to LLCs, and while the state permits prepayment penalties, there must still be compliance with fair lending standards, including proper disclosure.

Illinois. Illinois has regulations that are more borrower-friendly for residential mortgage loans. Specifically, the Illinois Residential Real Property Disclosure Act prohibits prepayment penalties on loans secured by a one-to-four dwelling unit residential property and made to an individual where the interest rate on the loan exceeds 8%. However, prepayment penalties on business-purpose loans made to LLCs are permissible as long as they are clearly outlined in the loan agreement and comply with disclosure requirements. LLCs are categorized as business borrowers, and PPPs are generally enforceable.

New York. In New York, prepayment penalties on residential loans are prohibited under Banking Law Section 6-l, except in the case of business-purpose loans, but the restrictions differ depending on property type, occupancy, and time restrictions on when a lender can charge the penalty.

Prepayment penalties are typically enforceable for LLCs and other business entities, provided they do not violate usury laws. New York’s legal landscape focuses on the borrower’s use of the property and whether the loan is tied to an investment or a business purpose. Prepayment penalties must be reasonable and disclosed upfront in accordance with state disclosure laws.

Pennsylvania. Residential loans that involve LLC borrowers typically fall under stricter regulations. Section 406 of the Loan Interest and Protection Law allows prepayment penalties on business-purpose loans, but there are threshold limits on one-to-two dwelling unit residential properties.

Under 10 Pa. Code § 7.2, a “residential mortgage loan” is subject to the prohibition against prepayment penalties for loans of $312,159 or less and secured by a one-to-two family dwelling. However, the definition excludes loans made to a person in the business of residential building or development when the financing is used to construct a one-to-two family dwelling. To qualify for this exclusion, the transaction must be bona fide construction financing to a builder or developer and not a device for evading compliance with the Pennsylvania Loan Interest and Protection Law. For LLCs, prepayment penalties may apply to commercial loans, provided the penalties are disclosed in writing and comply with the usury limits.

Texas. In Texas, prepayment penalties are allowed for both residential and commercial loans, but certain limits apply. The Texas Finance Code prohibits prepayment penalties, unless the loan is secured by a one-to-four dwelling unit residential property and a business-purpose loan. Even then, there are restrictions, depending on the interest rate and whether the property is owner-occupied. Prepayment penalties on loans made to Texas LLCs are less restrictive than New Jersey’s and typically are enforceable on loans where the property is used for business purposes. However, loans involving residential properties with business components (e.g., mixed-use properties) may face stricter scrutiny.

Other States. Louisiana, Maryland, Minnesota, Mississippi, and Ohio have very nuanced and specific prepayment penalty restrictions. Lenders should seek legal counsel when structuring loans in any state that has prepayment penalty restrictions.

If you have questions about how New Jersey’s statutory revisions or a particular state’s prepayment penalties may impact your lending practices or investment strategies, please reach out to the Banking & Finance team at Fortra.