Prepayment Penalty

A prepayment penalty is any fee or charge a lender imposes when a borrower pays off a loan before its scheduled maturity, compensating the lender for lost future interest income. Structures range from simple step-down penalties (e.g., 5%-4%-3%-2%-1% of balance by year) common on bridge and DSCR loans, to more complex yield maintenance or defeasance formulas common on permanent and CMBS loans.

Prepayment penalties protect a lender's expected yield on a loan, since a borrower who refinances or sells shortly after closing deprives the lender of the interest income it underwrote and priced the loan around. The structure and severity of the penalty vary enormously by loan type and are one of the most important terms to compare across competing loan offers.

Simpler step-down penalties, common on bridge and DSCR-rental loans, charge a declining percentage of the loan balance based on how many years into the term the prepayment occurs, and are straightforward for a borrower to estimate in advance. More complex formulas — yield maintenance and defeasance — are common on permanent, agency, and CMBS loans, and their cost depends on where interest rates sit at the time of prepayment relative to the loan's original rate, making them harder to predict at closing.

Some loans include a modest prepayment-penalty-free window (or allow a limited annual paydown, such as 20% of the original balance per year with no penalty) even within a step-down or yield maintenance structure — borrowers should always negotiate for the most flexible prepayment terms available given their expected hold period.

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