Step-Down Prepayment

What Is a Step-Down Prepayment Penalty?

A step-down prepayment penalty is a fee for paying off a commercial real estate loan early, calculated as a percentage of the outstanding loan balance that decreases each year. The penalty follows a preset schedule negotiated at origination, starting higher and "stepping down" over time until it reaches zero or the loan enters an open prepayment period.

The most common example: a 5-4-3-2-1 schedule on a 10-year loan with a 5-year lockout. The borrower cannot prepay at all during years one through five. In year six, the penalty is 5% of the remaining balance. Year seven drops to 4%, then 3%, 2%, 1%, and sometimes zero in the final months before maturity.

How It Works in Practice

Say a borrower has a $5 million commercial mortgage with a 5-4-3-2-1 step-down schedule starting in year six of a 10-year term. The remaining balance in year seven is approximately $4.6 million. The prepayment penalty at that point is 4% of $4.6 million, or about $184,000. If they wait until year nine, the penalty drops to 2% of the then-remaining balance, roughly $88,000 on a $4.4 million balance.

The math is simple, which is the whole point. Unlike defeasance or yield maintenance, a step-down penalty requires no Treasury rate lookups, no securities portfolio construction, and no defeasance consultant. You multiply the remaining balance by the applicable percentage. Done.

Common Step-Down Structures

The schedule is always stated in the loan documents (often in the promissory note or a prepayment rider). There is no ambiguity about what the borrower owes at any point during the term.

Step-Down vs. Other Prepayment Methods

Commercial real estate loans use several different prepayment structures. Knowing the differences helps brokers guide borrowers toward the right loan product based on their exit timeline.

The critical distinction: step-down penalties are predictable. A borrower who closes a loan with a 5-4-3-2-1 schedule knows exactly what they will pay to exit in year eight. With yield maintenance, the cost depends on where Treasury rates are at the time of prepayment, which nobody can predict at origination.

When Step-Down Penalties Matter for Brokers

Value-Add Deals with a Defined Exit

If the borrower's business plan is to stabilize a property over two to three years and then sell or refinance, the prepayment structure directly affects the economics. A step-down penalty lets them model the exit cost with precision. Yield maintenance or defeasance adds an unknown variable.

Rate Environment Sensitivity

In a falling rate environment, yield maintenance penalties increase because the spread between the loan's note rate and current Treasuries widens. A borrower locked into a 7% loan when Treasuries are at 3.5% faces a steep yield maintenance bill. A step-down penalty is immune to rate movements. If the schedule says 3%, it is 3% regardless of what the Fed does.

Conversely, in a rising rate environment, yield maintenance penalties shrink (and can even approach zero). In that scenario, a step-down penalty could be more expensive than yield maintenance would have been. But most borrowers and lenders value the certainty of knowing the cost upfront.

Negotiating at Origination

Step-down terms are one of the few prepayment structures where the broker has real negotiating leverage. Unlike CMBS loans (where defeasance or yield maintenance is essentially non-negotiable), bank and credit union loans leave room to shape the schedule. A strong borrower with a stabilized asset can often push for a shorter step-down (3-2-1 instead of 5-4-3-2-1) or an open window in the final 12 months.

The key is to negotiate prepayment terms at the term sheet stage, not after. Once the borrower signs loan documents, the schedule is locked.

Calculating the Cost

The formula is straightforward:

Prepayment Penalty = Outstanding Loan Balance x Step-Down Percentage

For a $7 million loan with a remaining balance of $6.5 million in a year where the step-down is 3%:

$6,500,000 x 0.03 = $195,000

Compare that to yield maintenance on the same loan, where the penalty depends on the rate spread and remaining term. If the note rate is 6.5% and the comparable Treasury is at 4.0%, yield maintenance on that balance with several years remaining could easily exceed $500,000. Or it could be less than $100,000 if rates have risen above the note rate. The borrower does not know until the day they prepay.

Which Lenders Offer Step-Down Structures

Step-down prepayment penalties are primarily a portfolio lender product. These are lenders who hold loans on their own balance sheet rather than securitizing them:

• Commercial banks. Most banks use step-down structures as their default prepayment mechanism on fixed-rate commercial mortgages.
• Credit unions. Similar to banks, with generally more borrower-friendly schedules.
• Life insurance companies. Some life companies offer step-down options, though many prefer yield maintenance on longer-term fixed-rate loans.
• Agency lenders (selectively). Certain Fannie Mae and Freddie Mac multifamily products include step-down provisions, though yield maintenance and defeasance are more common in agency executions.

CMBS conduit loans almost never use step-down structures. The securitization model requires either defeasance or yield maintenance to protect bondholders from prepayment risk.

Open Periods

Many loans with step-down penalties include an "open period" near the end of the term, typically the last 3 to 6 months, during which the borrower can prepay with no penalty at all. This gives the borrower a window to refinance or sell without any exit cost, as long as they time it right.

Open periods are especially common in bank loans and some permanent financing structures. If the borrower's plan involves holding the property for most of the loan term and refinancing near maturity, an open period is worth requesting at the term sheet stage.

Disclaimer: This glossary entry is for educational purposes only and does not constitute financial, legal, or investment advice. Prepayment terms and penalties vary by lender and loan product. Consult with a qualified commercial real estate professional and review your specific loan documents for exact prepayment provisions.

Frequently Asked Questions