Prepayment Penalty

What Is a Prepayment Penalty?

A prepayment penalty is a fee that a commercial real estate lender charges when a borrower pays off a loan before its scheduled maturity date. The penalty compensates the lender for the interest income it would have earned had the loan stayed in place for the full term. Prepayment penalties are standard in most fixed-rate commercial mortgages, including CMBS loans, bank loans, life company loans, and HUD/FHA multifamily financing.

For borrowers, prepayment penalties are one of the most important terms in a commercial mortgage. They directly affect your ability to sell, refinance, or restructure debt before the loan matures, and the cost of doing so can range from trivial to deal-breaking.

Why Lenders Charge Prepayment Penalties

When a lender originates a commercial mortgage at, say, 6.5% for 10 years, they are counting on that income stream for the full decade. If rates drop to 5% two years later and the borrower refinances, the lender loses eight years of above-market interest. The prepayment penalty exists to make the lender whole, or at least close to it.

This is especially true in the CMBS market. When a loan gets securitized and sold to bond investors, those investors bought a specific yield profile. Early payoff disrupts the bond structure. That is why CMBS loans carry the strictest prepayment protections in commercial real estate.

Types of Prepayment Penalties

Commercial loans use four primary prepayment structures. The loan documents specify which one applies, and it is rarely negotiable after closing.

Yield Maintenance

Yield maintenance is a formula-based penalty that calculates the present value of the interest the lender would lose due to early payoff. The core idea: the penalty makes up the difference between the loan's interest rate and the current Treasury rate for the remaining term.

If your loan rate is 6.5% and comparable Treasuries are at 4%, the penalty is steep because the lender is losing 2.5% annually on the remaining balance. If Treasuries are at 7%, the penalty is minimal or zero because the lender can reinvest at a higher rate. You can estimate your yield maintenance cost with our yield maintenance calculator.

Yield maintenance is common in portfolio loans from banks, life companies, and some CMBS loans.

Defeasance

Defeasance is not technically a penalty. Instead of paying cash, the borrower replaces the property as loan collateral with a portfolio of U.S. Treasury securities that replicate the remaining loan payments exactly. The loan stays in place, but the property is released from the mortgage.

The cost depends on Treasury prices at the time. When Treasury yields are below the loan rate, defeasance is expensive because you need more securities to generate the same cash flow. When yields are above the loan rate, it can actually cost less than the remaining balance. Defeasance is the standard prepayment mechanism for most CMBS loans. Use the defeasance cost estimator for a ballpark figure.

Step-Down Penalties

Step-down penalties (also called declining prepayment penalties) start at a higher percentage and decrease over the loan term. A common structure is 5-4-3-2-1, meaning the penalty is 5% of the remaining balance in year one, 4% in year two, and so on until it reaches zero.

Step-downs are the most predictable prepayment structure. You know exactly what the penalty will be at any point during the loan. They are common in bank loans and some bridge-to-permanent financing structures.

Flat Penalties

A flat penalty is a fixed percentage of the remaining loan balance, regardless of when prepayment occurs. Typical flat penalties range from 1% to 3%. Some loans combine a lockout period with a flat penalty: no prepayment for two years, then a 2% penalty for the remaining term.

Flat penalties are the simplest to understand and the cheapest for borrowers in most scenarios. They appear more often in shorter-term loans and some credit union products.

Prepayment Penalty Structures Compared

Lockout Periods vs. Open Prepayment Windows

Most commercial loans have three distinct phases for prepayment:

The lockout period is the initial window, typically one to three years, where no prepayment is allowed at all. You cannot pay off the loan during this time regardless of what penalty you are willing to pay.

The penalty period follows the lockout. Prepayment is permitted, but only with the applicable penalty (yield maintenance, defeasance, step-down, or flat).

The open window is the final period before maturity, usually the last three to six months, where the borrower can pay off the loan at par with no penalty. This window exists because both parties benefit from a clean transition near maturity.

A typical 10-year CMBS loan might have this structure: 2-year lockout, defeasance required for years 3 through 9.5, open prepayment for the final 6 months.

How Interest Rates Affect Prepayment Costs

The interest rate environment at the time of prepayment dramatically affects the cost of yield maintenance and defeasance. This is something borrowers often underestimate.

In a falling rate environment (rates drop after origination), prepayment penalties are expensive. The lender is losing above-market income, so the penalty compensates for that gap. A borrower with a 7% loan trying to refinance when comparable rates are 5% faces a significant penalty.

In a rising rate environment (rates increase after origination), prepayment penalties shrink. The lender can reinvest at a higher rate, so the economic loss is minimal. Yield maintenance formulas may produce a penalty close to zero, and defeasance securities may cost less than the remaining balance.

Step-down and flat penalties are unaffected by rate movements, which is both their advantage (predictability) and disadvantage (you pay the same penalty even when rates rise).

Negotiating Prepayment Terms

The time to negotiate prepayment terms is before you sign. Once the loan closes, the prepayment structure is contractually locked.

Borrowers with leverage, meaning strong credit, low loan-to-value, a desirable property, or multiple competing term sheets, can often negotiate more favorable prepayment terms. Common requests include:

• Shorter lockout periods (one year instead of two)
• Step-down structure instead of yield maintenance
• Lower step-down percentages (3-2-1 instead of 5-4-3-2-1)
• Wider open prepayment windows (12 months instead of 3)
• Prepayment with a flat fee after a certain date

With CMBS loans, prepayment terms are largely standardized and non-negotiable. If flexibility matters, a bank or life company loan may be a better fit even at a slightly higher rate.

Prepayment Penalties by Loan Type

What Brokers Should Tell Clients

Prepayment penalties are one of the most overlooked deal points in commercial lending. Brokers who proactively address them earn trust and prevent surprises later.

Always model the exit. Before the client signs, run the numbers on what it would cost to sell or refinance in year 3, year 5, and year 7. If the client's business plan involves a sale or refinance within the loan term, the prepayment structure should align with that timeline. A client who plans to sell in five years should not be in a 10-year CMBS loan with defeasance unless the numbers still work.

Match the loan to the hold period. If the client expects to hold the property for 3 to 5 years, a 5-year bank loan with a step-down penalty is a better fit than a 10-year CMBS loan with defeasance, even if the CMBS rate is 50 basis points lower. The rate savings rarely offset a six-figure defeasance cost.

Know the open window dates. When advising a client on disposition timing, check the loan's open prepayment window. Closing the sale during that window eliminates the penalty entirely. Sometimes pushing a sale back by a few months saves hundreds of thousands of dollars.

Frequently Asked Questions