Prepayment Penalty
A fee charged for paying off a loan before maturity, protecting the lender's expected yield.
A prepayment penalty is a fee a lender charges when a borrower pays off a loan early. Lenders count on a set stream of interest, so paying off early cuts that yield short. The penalty compensates them and shapes how and when a borrower can refinance or sell.
Common structures include step-down penalties, which fall over time such as 5% in year one down to 1% in year five, and yield maintenance, which makes the lender whole for lost interest. Defeasance, used on many CMBS loans, replaces the collateral with government securities that reproduce the payments.
Yield maintenance and defeasance can be expensive when rates have fallen since closing, sometimes reaching six or seven figures on large loans. Borrowers weigh these exit costs against the benefit of refinancing or selling before the penalty burns off.
Formula
Step-down, yield maintenance, or defeasance protect lender yield
Worked Example
A borrower whose step-down penalty starts at 5% and drops one point a year repays a $2,000,000 loan in year two. The penalty is 4% of the balance, or about $80,000. Waiting until after year five would remove it entirely.
Why It Matters
Prepayment terms can make an early refinance or sale far more expensive than expected. Understanding the structure before closing lets you time your exit and avoid a surprise six-figure fee.
Related Terms
Related Programs and Tools
Frequently Asked Questions
What is a step-down prepayment penalty?
It is a penalty that shrinks each year, such as 5% in year one down to 1% in year five, then disappears. It rewards borrowers who hold the loan longer.
What is defeasance?
Defeasance replaces your loan's collateral with government securities that reproduce the remaining payments. It is common on CMBS loans and can be costly when rates have dropped.