The four kinds of prepayment penalty
Most fixed-rate commercial loans charge a fee if you pay them off before maturity. The lender priced the loan expecting a stream of interest payments, and the penalty compensates it for losing them. Your note will use one of four structures:
- Step-down (declining). A fixed percentage of the balance that drops each year, such as 5% in year one, 4% in year two and so on. Common on bank, credit union, DSCR and private loans.
- Yield maintenance. A formula that charges the lost interest, measured against Treasury yields. Common on life-company, agency multifamily and some bank loans.
- Defeasance. Instead of paying a fee, you buy a portfolio of Treasury securities that replaces the loan's payments. Used on most CMBS loans. The cost tracks yield maintenance closely, plus legal and consultant fees.
- Lockout. No prepayment at all for a set period, typically the first two to five years of a CMBS or life-company loan.
Almost every structure ends with an open period, usually the last three to six months before maturity, when you can pay off the loan for free.
How yield maintenance is calculated
Yield maintenance answers a simple question: if the lender takes your payoff money and buys Treasuries, how much interest does it lose compared with keeping your loan? The standard version looks like this:
discounted at the Treasury yield, and never less than the minimum (often 1% of the balance)
Two things drive the result. The first is the gap between your note rate and the Treasury yield for the remaining term. If yields have risen above your rate, the formula produces zero and only the 1% floor applies. The second is time: the more months left until the open period, the more lost interest there is to replace.
The Treasury yield is not something we can pick for you. Your note names the benchmark (often the Treasury with a maturity closest to the loan's remaining term, sometimes an interpolated yield), and the yield changes every day. Enter today's figure from the U.S. Treasury's daily yield curve for an estimate, and get a written payoff quote from your servicer before you commit.
Worked example
An owner has $2,000,000 left on a loan with a 6.5% note rate and 60 months until the open period. If the comparable Treasury yields 4.0%:
- Monthly interest differential: $4,166.67
- Present value over 60 months at 4.0%: $226,246, about 11.3% of the balance
- The 1% floor ($20,000) is lower, so the formula amount applies.
If that owner could refinance at 5.5%, interest savings would be about $1,666.67 a month, or $100,000 over the same 60 months: less than the penalty. On these numbers, refinancing only to lower the rate doesn't pay. If the Treasury yield were 6.0%, the penalty would drop to $43,105. The same loan can cost very different amounts to pay off depending on the week you do it.
Step-down penalties
A step-down penalty is easier to work out: multiply the balance by the percentage for the current loan year. On a 5-4-3-2-1 schedule, paying off $2,000,000 in month 30 (loan year three) costs $60,000. Waiting 6 months until year four drops it to $40,000. The second calculator shows the next step and how much waiting saves, which helps when your sale or refinance date has some flexibility.
Is it worth paying the penalty?
Paying a penalty can still be the right call. The common cases:
- Cash out. If the property has gained value, the equity you can pull may be worth far more than the penalty. The cash-out refinance calculator shows how much is available.
- A much lower rate with plenty of time left on the loan, so savings build up past the penalty.
- A sale where the buyer can't assume the loan and the price makes the penalty a rounding error.
- Getting out of a bad structure, such as a floating rate, a recourse loan or a lender that won't approve a lease you need.
Rate savings alone rarely beat yield maintenance, because the formula is designed to charge you roughly the interest you'd save. Run the full comparison, with closing costs, in the commercial refinance calculator.
Ways to reduce or avoid the penalty
- Time it. Close in the open window, or just after a step-down anniversary.
- Read the partial prepayment clause. Some notes let you pay down 10–20% a year without a penalty.
- Ask about assumption. On a sale, a buyer taking over the loan avoids the penalty altogether, for a fee.
- Negotiate on the next loan. If you expect to sell or refinance early, ask for a step-down or a shorter penalty period up front; it usually costs a little more in rate.