What Is Prepayment Penalty?
Lenders expect to earn interest over the life of the loan. When you refinance or sell and pay off early, they lose that income. The prepayment penalty makes you whole—or partially whole—for that loss. In commercial loans, it's almost standard: yield maintenance (you pay the present value of lost interest) or a step-down (e.g., 5% of balance in year 1, 4% in year 2, etc.). Residential loans sometimes have prepay penalties for the first 2–5 years. Always read your promissory note and factor the penalty into your refinance or sale timing.
A prepayment penalty is a fee charged by the lender when you pay off a loan before its scheduled maturity. It compensates the lender for lost interest and is common in commercial loans, construction loans, and some residential mortgages.
At a Glance
- What it is: Fee for paying off a loan before maturity
- Common in: Commercial loans, construction loans, hard money
- Types: Yield maintenance, step-down, percentage of balance
- Typical period: 2–5 years for residential; 3–7 for commercial
- Planning: Factor into refinance and balloon payment timing
How It Works
Why lenders charge it
A lender prices a 10-year loan expecting 10 years of interest. If you pay off in year 3, they get 7 fewer years of income. They also have to reinvest the principal—possibly at a lower rate. The prepayment penalty compensates for that. It's not punishment; it's contractually agreed compensation.
Yield maintenance
The most common structure in CMBS and institutional commercial loans. You pay the lender the present value of the interest they would have received from your payoff date to the loan's maturity. Formula: (Remaining interest payments) discounted at the Treasury rate the lender can reinvest at. In practice, the lender (or servicer) calculates it. Can be 5–15% of the loan balance in early years. Decreases as you approach maturity—less interest left to "make whole."
Step-down (declining penalty)
A simpler structure: X% of the outstanding balance if you prepay in year 1, (X-1)% in year 2, etc. Example: 5% in year 1, 4% in year 2, 3% in year 3, 2% in year 4, 1% in year 5, 0% after. A $1 million loan prepaid in year 2 would incur a 4% penalty = $40,000. Predictable and easy to model.
Percentage of balance
Some loans use a flat percentage—e.g., 2% of the balance regardless of when you prepay. Simpler but can be costly if you prepay late in the term when the lender has already received most of the interest.
Residential prepay penalties
Less common than commercial but still exist. Often 2–5 years, with a cap (e.g., 6 months of interest or 2% of balance). Some states restrict or prohibit them. Check your closing disclosure and state law.
Real-World Example
Maria has a commercial loan on a 20-unit in Atlanta: $1.5 million, 6% rate, 10-year term with 5-year yield maintenance prepayment penalty. At year 3, she wants to refinance to pull out equity. The penalty: present value of 7 years of interest (years 4–10) discounted at the current Treasury rate. The servicer calculates: $98,000.
Maria's refinance would pull out $200,000 in equity. After the $98,000 penalty and $15,000 in refi costs, she nets $87,000. Still worth it for her plans—but the penalty ate nearly half the benefit. If she'd waited 2 more years, the penalty would have dropped to ~$45,000. Timing matters.
Pros & Cons
- Lenders may offer lower rates in exchange for prepay protection
- Predictable for step-down structures—you can model the cost
- After the penalty period, you're free to refinance or sell
- Commercial borrowers accept it as the cost of institutional capital
- Limits flexibility to refinance when rates drop
- Yield maintenance can be large in early years
- Sale or refinance timing becomes constrained
- Reduces proceeds when you need to exit
Watch Out
Model the penalty before you sign: Ask the lender for a sample calculation at year 3, 5, and 7. Know what you're agreeing to.
Refinance timing: If you're doing BRRRR or expect to refinance soon, negotiate a shorter penalty period or a step-down that steps to zero quickly. Don't assume you'll hold past the penalty—plans change.
Sale vs refinance: The penalty applies to both. If you sell, the buyer's lender pays off your loan—and the penalty comes from your sale proceeds. Factor it into your net.
Assumption alternative: Some commercial loans are assumable. If the buyer assumes your loan, there's no payoff—and no prepayment penalty. Worth exploring in a sale scenario.
The Takeaway
Prepayment penalties are the trade-off for lower rates and institutional capital. Understand the structure—yield maintenance, step-down, or flat percentage—and model the cost at different exit points. Plan your refinance and balloon payment timing around the penalty period. When possible, negotiate a shorter period or more favorable structure.