Prepayment Penalties: What is Your Exit Strategy?

Feb 10, 2025

When you prepay a commercial real estate loan, it often comes with a cost – prepayment penalties.  Lenders use these as risk mitigation tools to hedge against the loss of interest income over the loan term.

  1. Step-Down Penalty – A declining penalty based on the remaining loan balance at the time of prepayment.  There is typically a gradual reduction of the penalty as a loan gets closer to maturity.

    Example: 5-4-3-2-1 schedule on a five-year loan means the penalty is 5% in Year 1, 4% in Year 2, 3% in Year 3, and so on. 


  2. Yield Maintenance – This type of prepayment penalty is designed to compensate lenders for the interest they would have earned if the loan had remained until maturity.   The borrower will be charged to ensure the lender receives a similar yield even if the loan is paid off early.  The calculation for this penalty involves the present value of the remaining loan payments.

    Formula: (Amount of principal being prepaid) x (Interest Rate – Treasury Rate) x (PV Factor)


  3. Defeasance – The process in which the borrower is released from their debt obligation by purchasing a portfolio of securities, typically treasury bonds, as replacement collateral to secure the debt and to generate the cash flows that replicate the scheduled payments of principal and interest remaining on the loan. 


  4. Flat Fee – A flat fee or percentage charged regardless of timing. 


  5. Minimum Guaranteed Interest – This structure ensures the lender earns a minimum amount of interest, regardless of when the loan is prepaid.  This is typically more common in shorter-term or bridge loans and is expressed as a number of months of guaranteed interest.

    Example: A bridge loan with a 2-year term and 6 months of guaranteed interest ensures the lender will receive a total of at least 6 months of interest payments if the borrower prepays before 6 months.

Understanding these structures helps you align financing with your investment strategy.  One of the first questions to ask when securing financing is “what is your exit plan?”  Whether you intend to refinance or sell the property a couple years into the loan term, knowing how expensive it is to prepay your loan is critical as it can directly impact your investment returns.