A prepayment penalty is a fee a commercial borrower pays for repaying a loan before maturity, compensating the lender for lost interest. It takes several forms, including step-down percentages, yield maintenance, and defeasance, each imposing a different cost. The penalty protects the lender's expected yield and shapes the true cost of selling or refinancing early.
What Is a Prepayment Penalty?
A prepayment penalty is a charge that compensates a lender when a borrower repays a commercial loan ahead of schedule. Because early payoff denies the lender interest it expected, the penalty restores some or all of that lost yield. Per CommLoan and Commercial Real Estate Loans, the most common structures are lockout, step-down, yield maintenance, and defeasance.
The structures range from simple to complex. A step-down is a declining percentage of the balance. Yield maintenance and defeasance are Treasury-based and preserve the lender's full yield, so they are costlier when rates have fallen below the loan coupon. A lockout is not a fee at all but a period during which prepayment is barred entirely.
Structure | How the cost is set | Relative complexity |
Lockout | Prepayment prohibited; no payoff allowed | None, but no exit |
Step-down | Fixed percent of balance, declining yearly | Low |
Fixed | Flat percent of balance for the term | Low |
Yield maintenance | PV of lost interest at Treasury yield | High |
Defeasance | Treasury portfolio replaces collateral | Highest |
Per Commercial Real Estate Loans, many loans combine a lockout with another structure, for example a lockout followed by a yield maintenance or step-down window, then an open period near maturity.
Why Prepayment Penalties Matter
Prepayment penalties matter because they determine the true cost of exiting a loan early, which can decide whether a sale or refinance makes sense. A penalty can turn a profitable early sale into a wash. The Treasury-based structures are especially sensitive: when market rates sit below the loan coupon, yield maintenance and defeasance premiums can reach several percent of the balance.
The structure is set at origination and is often non-negotiable, so it must be underwritten as a real transaction cost, not an afterthought. The quotable point for an operator: the prepayment structure written into a loan at closing can cost more at exit than the interest rate ever saved. A step-down of 5 percent in year one is predictable; a yield maintenance premium moves daily with Treasury yields.
Per CommLoan, a common step-down schedule declines from 5 percent of the outstanding balance in year one to 4 percent in year two, 3 percent in year three, and so on, giving borrowers a clear, falling cost of early exit that Treasury-based penalties do not offer.
Example
Consider a $4,000,000 loan with a 5-4-3-2-1 step-down penalty, prepaid in year two. The penalty is a fixed percentage of the outstanding balance tied to the loan year. The table shows the cost at each point in the schedule.
Loan year | Penalty rate | Penalty on $4,000,000 |
Year 1 | 5% | $200,000 |
Year 2 | 4% | $160,000 |
Year 3 | 3% | $120,000 |
Year 4 | 2% | $80,000 |
Year 5 | 1% | $40,000 |
Prepaying in year two costs 4 percent of $4,000,000, or $160,000. Waiting one more year into year three drops the penalty to 3 percent, or $120,000, a $40,000 saving for a one-year delay. Unlike yield maintenance, this cost is known in advance and does not move with Treasury rates, which is why borrowers who expect to sell early often prefer a step-down.
Variations and Edge Cases
Prepayment penalty behavior depends on the loan program, the rate environment, and where the loan sits in its term. The table covers variants an operator should confirm before pricing an early payoff.
Variant | Treatment |
Lockout period | Prepayment barred outright, common on CMBS for the first 24 to 36 months |
Step-down | Declining fixed percentage, the most borrower-friendly structure |
Yield maintenance | PV of lost interest; large when the coupon exceeds Treasuries |
Defeasance | Treasury portfolio swap; often the only CMBS option, weeks to execute |
Open window | Final months usually allow prepayment at par with no penalty |
Minimum floor | Treasury-based penalties often carry a 1 percent minimum fee |
The common mistake is assuming any loan can be paid off for a modest fee. A CMBS loan may forbid prepayment entirely and require defeasance, a securities transaction costing tens of thousands in third-party fees on top of the securities premium. Confirm the exact structure and any lockout before underwriting an exit.
Prepayment Penalty vs Yield Maintenance
A prepayment penalty is often equated with yield maintenance, but yield maintenance is only one type of prepayment penalty. A prepayment penalty is the general category of any fee for early payoff. Yield maintenance is a specific structure within it, equal to the present value of the lender's lost interest discounted at a matched Treasury yield.
The practical difference is scope. Every yield maintenance charge is a prepayment penalty, but not every prepayment penalty is yield maintenance. A step-down penalty and a defeasance requirement are also prepayment penalties, and they cost very differently. Identifying which structure a loan carries is the first step in pricing an early sale or refinance.
Frequently Asked Questions
What is a prepayment penalty in commercial real estate?A prepayment penalty in commercial real estate is a fee a borrower pays for repaying a loan before maturity, compensating the lender for lost interest. It takes several forms, including step-down percentages, yield maintenance, and defeasance, each imposing a different cost and shaping the true expense of selling or refinancing early.
What are the types of prepayment penalties?The main types of prepayment penalties are lockout, step-down, fixed, yield maintenance, and defeasance. Lockout bars prepayment entirely. Step-down and fixed penalties are percentages of the balance. Yield maintenance and defeasance are Treasury-based and preserve the lender's full yield, per CommLoan and Commercial Real Estate Loans.
How much is a prepayment penalty?Prepayment penalty cost depends on the structure. A common step-down runs 5 percent of the balance in year one, declining yearly, per CommLoan. Yield maintenance and defeasance can reach several percent of the balance when market rates sit below the loan coupon, and defeasance adds tens of thousands in third-party fees.
Related Terms
Yield Maintenance
Defeasance
CMBS Loan
Permanent Loan
Cash Out Refinance