| Detail | Explanation |
|---|---|
| Also called | Prepayment premium, exit fee, prepay |
| Step-down | Fixed percentage of the balance that declines on a schedule |
| Market-based forms | Yield maintenance and defeasance |
| Related terms | Lockout period, open period, minimum interest |
What types of prepayment penalties do commercial loans use?
- Step-down: a declining percentage of the balance, written as a schedule such as 3-2-1 or 5-4-3-2-1
- Yield maintenance: a premium based on the loan rate versus Treasury yields over the remaining term
- Defeasance: collateral substitution with government securities, common on CMBS loans
- Lockout: prepayment prohibited for a set period
- Minimum interest: a bridge or construction loan requires a set number of months of interest regardless of payoff date
- Exit fee: a flat charge at payoff, sometimes waived if the lender provides the refinance
- Open period: a window near maturity with no premium
How does a step-down prepayment schedule work?
A step-down charges a fixed share of the amount prepaid, and the share drops on each loan anniversary. A 3-2-1 schedule charges the highest percentage in year 1, a lower one in year 2, a lower one again in year 3, and nothing after. Because the charge does not depend on interest rates, the borrower knows the exit cost on day 1, which is why step-downs are common on bank, credit union, and bridge loans.
Worked example: a 3-2-1 step-down
In this hypothetical example, a sponsor takes a $6,000,000 loan with a 3-2-1 step-down, meaning 3% in year 1, 2% in year 2, and 1% in year 3, then open. The table shows the charge for repaying the full balance in each year, ignoring amortization.
| Prepayment in | Premium rate | Premium |
|---|---|---|
| Year 1 | 3% | $180,000 |
| Year 2 | 2% | $120,000 |
| Year 3 | 1% | $60,000 |
| Year 4 and later | 0% | None |
How do you choose a prepayment structure?
Start with the business plan. A sponsor planning to sell after lease-up in 2 years should weight exit cost heavily and may accept a higher rate for a short step-down or a bridge loan with only minimum interest. A long-term holder refinancing a stabilized asset can often accept yield maintenance or defeasance for better proceeds or pricing. The yield maintenance vs defeasance guide explains how those 2 compare.
Model the total cost of each option across several exit dates, including the premium, the rate, and fees. The commercial mortgage calculator helps compare payments at different rates.
What to check in the prepayment clause
Read whether the premium applies to partial prepayments, whether payoffs from casualty or condemnation proceeds are exempt, whether the schedule runs from closing or from the first payment date, whether a loan assumption on sale is allowed, and when the open period begins. Clauses vary by lender and loan, so have counsel review the terms before signing. Capital Partners compares prepayment across lenders together with proceeds, rate, and recourse. Submit a deal to see how the options fit a hold period.
Common questions
Do all commercial loans have prepayment penalties?
Many do, especially fixed-rate loans. Some floating-rate bank and bridge loans have little or no prepayment cost after a minimum interest period. The note sets the terms.
What does 5-4-3-2-1 prepayment mean?
It is a step-down schedule. The premium is 5% of the prepaid balance in year 1, 4% in year 2, 3% in year 3, 2% in year 4, and 1% in year 5, and the loan is typically open after that.
Can a prepayment penalty be waived?
Lenders sometimes waive or reduce it when they provide the new loan, when the loan is assumed on a sale, or when the note allows it for casualty payoffs. Waivers are negotiated case by case.
Is a step-down cheaper than yield maintenance?
It depends on rates and timing. When Treasury yields have fallen, yield maintenance usually costs more. When they have risen, yield maintenance can drop to its minimum and cost less than a fixed step-down.
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