Prepayment penalties explained: step down to defeasance

The prepayment terms in a loan can matter as much as the rate. They decide what it costs to sell, refinance, or pay off early, and they are hard to change after closing. Most commercial loans use one of three structures. Each behaves differently when plans change, so it pays to understand them before you sign.

Why lenders charge for early payoff

A lender prices a loan expecting to earn interest for a set period. Many lenders also fund that loan with money committed for a matching term. When a borrower pays off early, the lender has to put the money back to work, often at a lower rate. The prepayment penalty compensates for that. What it costs you depends on the structure and on where rates are when you exit.

Step down prepayment

A step down schedule sets the penalty as a fixed percentage of the outstanding balance, and that percentage declines over time. A common pattern is 5, 4, 3, 2, 1. That means five percent of the balance in year one, four percent in year two, and so on, with no penalty after year five.

• The cost is easy to calculate on any date.
• It does not move with interest rates.
• It is common with banks, credit unions, and DSCR rental lenders.

Predictability makes it easier to plan a sale or refinance. In exchange, a lender may price the loan a little higher for that flexibility.

Yield maintenance

Yield maintenance aims to make the lender whole for the interest it would have earned through a set date. The formula compares the loan rate to a Treasury yield with a similar remaining term. The penalty is roughly the present value of that difference over the remaining period.

The result moves with the market:

• When Treasury yields fall below your loan rate, the penalty grows.
• When yields rise above it, the penalty shrinks, usually down to a stated minimum such as one percent of the balance.

Yield maintenance appears in many life company, agency, and fixed rate bank loans. Read the exact formula. Details like the discount rate and the end date of the calculation can change the number materially.

Defeasance

Defeasance is standard in CMBS loans. The loan is not actually paid off. Instead, the borrower buys a portfolio of government securities that produces the payments the loan would have made through maturity or the open period. That portfolio replaces the property as collateral, and the property is released.

The economics are similar to yield maintenance, but the process is more involved. It typically requires a defeasance consultant, a successor borrower entity, accountants, and legal counsel. Those costs come on top of the securities. Plan on several weeks. Some CMBS loans allow yield maintenance as an alternative, and some allow defeasance only after a lockout period.

What to check in the term sheet

The headline structure is only part of the story. Before you commit, confirm:

• Lockout. Some loans cannot be prepaid at all for an initial period.
• Open window. Many loans allow payoff without penalty in the final months before maturity. Know when it starts.
• Partial prepayment. Can you pay down part of the balance, or release one property from a pool?
• Assumption rights. If a buyer can assume the loan, a sale may not trigger the penalty at all.
• Sale versus refinance. Some lenders treat the two differently.

Then match the structure to the business plan. A value add plan with a likely sale in a few years usually fits a step down or floating rate loan better than defeasance. A stabilized, long term hold can often absorb a stricter structure, sometimes in exchange for better pricing.

If you hold a loan today and want to know what an early exit would cost, start with the maturity date and work backward. Our loan maturity planner helps map the timeline. To review a term sheet or the prepayment terms on an existing loan with us, get in touch.