A charge for repaying a loan before maturity, protecting the lender's expected yield.
The longer version
A prepayment penalty is a charge for repaying a loan before its maturity. In commercial real estate it is a negotiated term, and its purpose is to protect the lender's expected return, particularly on fixed-rate loans where early repayment would force the lender to reinvest at lower rates.
It comes in a handful of standard forms. A step-down structure charges a declining percentage of the balance, such as five percent in the first year falling by a point each year. Yield maintenance charges the present value of lost interest. Defeasance substitutes securities for the collateral rather than charging a fee. A lockout prohibits prepayment entirely for an initial period. Most loans also have an open window near maturity when the loan can be repaid at par.
Floating-rate loans usually carry lighter prepayment terms, often a short period of minimum interest or a small exit fee, because the lender's return already moves with the market.
Prepayment terms matter more than they look at origination, because they decide what a sale or refinance costs. A sponsor who expects to sell in three years and accepts a structure that is expensive in year three has priced its own exit.
Common questions
- What is a prepayment penalty on a commercial loan?
- A charge for repaying a loan before maturity, set in the loan documents. In commercial real estate it takes forms such as a step-down percentage, yield maintenance, defeasance or a lockout period.
- What is a step-down prepayment penalty?
- A penalty that starts at a set percentage of the balance and declines over time, for example 5, 4, 3, 2 and 1 percent in successive years, usually followed by an open period.
- Can you avoid a prepayment penalty?
- Usually only by waiting for the open period, negotiating the terms at origination, or having a buyer assume the loan. Some loans permit partial prepayment without penalty, and some lenders will negotiate when they are refinancing the loan themselves.
- Do floating-rate loans have prepayment penalties?
- Often lighter ones, such as a short minimum interest period or a small exit fee, because the lender's return already adjusts with the market.