Glossary
Prepayment Penalty
A prepayment penalty is a fee a borrower pays for repaying all or part of a loan before its scheduled maturity. It compensates the lender for lost interest income and reinvestment risk. Common forms include fixed percentage step-down schedules, yield maintenance and defeasance, and the terms are set in the loan documents.
Formula
Example
A $4,000,000 commercial loan has a 5-4-3-2-1 step-down prepayment schedule: 5% in year 1, 4% in year 2, 3% in year 3, and so on. If the borrower sells the property and repays the full $4,000,000 balance in year 3, the penalty is $4,000,000 x 3% = $120,000. Waiting until year 6, after the schedule ends, would avoid the penalty entirely.
How it is used in underwriting
Prepayment terms matter in underwriting because they limit a borrower's flexibility to sell or refinance. Equity investors model the penalty in exit scenarios, since an early sale can cost a meaningful share of profits. Lenders use prepayment protection to secure the yield they priced, especially on fixed rate loans that are funded or hedged for the full term. Floating rate bridge loans often have shorter protection, such as a minimum interest period, because the lender's funding cost adjusts with rates. SBA 7(a) loans with longer maturities carry their own declining prepayment fee in the early years.
The type of penalty matters as much as its existence. Step-down schedules are predictable. Yield maintenance and defeasance costs depend on interest rates at the time of prepayment: they are expensive when rates have fallen and can be modest when rates have risen. Borrowers should also check for open periods near maturity, partial prepayment rights, and whether the loan is assumable, since assumption can be an alternative to prepayment when selling. Failing to model these terms is a common underwriting error in value-add business plans that assume a refinance or sale within a few years.
Frequently asked questions
What are the types of prepayment penalties?
The main types are step-down schedules, which charge a declining percentage of the balance, yield maintenance, which compensates the lender for lost interest based on current rates, and defeasance, which substitutes Treasury securities for the loan collateral. Some loans also use lockout periods during which prepayment is not allowed at all.
Can you negotiate a prepayment penalty?
Often, yes. Borrowers can negotiate shorter step-down schedules, open prepayment windows before maturity, partial prepayment allowances, or a waiver if the loan is refinanced with the same lender. Expect tradeoffs: lenders may charge a higher rate or fee for more flexible prepayment terms.
Do SBA loans have prepayment penalties?
SBA 7(a) loans with maturities of 15 years or more generally carry a prepayment fee if more than a quarter of the balance is repaid within the first three years, declining each year. SBA 504 debentures have their own declining prepayment schedule. Borrowers should confirm the current terms with their lender.
Related terms
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