Prepayment Penalties
“Beat the term, meet the burn.”
(Prepayment Penalties in Fixed-Rate Comm’l Loans)
Prepayment penalties are fees imposed by lenders when a borrower pays off a fixed-rate commercial loan ahead of schedule. Prepayment penalties are designed to protect the lender’s financial interest, ensuring they recover part (or all) of the interest income they would have earned if the loan were repaid over its full term. Prepayment Penalties are common in fixed-rate commercial loans and less common in floating-rate commercial loans (but they do still occur, depending on the lender and loan type).
See: Prepayment Penalties (floating-rate commercial loans)
for a description of floating-rate loan prepayment penalties
Commercial loan prepayment penalties include:
Percentage of Loan Balance
A fixed percentage of the remaining loan balance is charged, typically decreasing over time in a “step-down” format (e.g., 5% in year one, 4% in year two, 3% in year three, etc.). This prepayment penalty structure is simple and predictable, making it common in commercial loans and, generally speaking, is typically the most favorable (read: least onerous) option for borrowers.
(see example below)
Yield Maintenance
A prepayment penalty ensuring a lender receives the same yield as if a loan were held to maturity. It compensates the lender for lost interest due to early payoff by requiring the borrower to pay the difference between the loan rate and (typically) current Treasury yields, preserving the lender’s expected return.
(see example below)
Break funding
Also known as “breakage costs”, refers to fees charged by lenders when a borrower repays a commercial loan before its scheduled maturity, disrupting the lender’s funding arrangement. When lenders extend a commercial loan, they often secure funding at a specific rate for a set term to match the loan’s repayment schedule (a practice called “match-funding”). If a borrower repays early, the lender may face losses due to differences between the originally secured rate and current market interest rates. For example, if rates have declined, the lender may earn less reinvesting the prepaid funds. Break funding fees are typically calculated based on the remaining balance, the time left on the loan, and the interest rate differential. These fees are common in certain fixed-rate commercial loans, in particular loans with complex financing structures.
(see example below)
Defeasance
A prepayment method used in commercial real estate loans where, instead of paying off the loan directly, the borrower replaces the collateral with government securities. These securities generate cash flows that match the loan’s remaining payments, ensuring the lender receives the full scheduled interest and principal. Defeasance allows property owners to release the property from the loan lien, often to facilitate a sale or refinancing without triggering penalties
See: Defeasance for more information on this exciting topic.
Discussion & Best Practices
- Prepayment penalties can significantly impact the cost-effectiveness of early repayment, often deterring borrowers from refinancing or selling properties prematurely. They are much more prevalent in commercial loans than residential mortgages.
- Understanding the terms of prepayment penalties is crucial for borrowers considering early repayment. Negotiating terms upfront or choosing loans with more flexible prepayment options can help minimize unexpected costs. Ultimately, borrowers must weigh the financial benefits of prepaying a loan against the potential penalties to make informed decisions
- With the understanding that it is in the Borrowers best interests to minimize prepayment penalties and the Lenders best interests to maximize prepayment penalties, it should also be understood that prepayment penalties are typically negotiable. If a Borrower finds that a particular Lender is unwilling or unable to modify an onerous or otherwise unreasonable prepayment penalty structure the Borrower should consider seeking another Lender.
Prepayment Penalty Examples
Percentage of Loan Balance (Step-Down)
A borrower has a $1 million commercial loan with a 10-year term and a step-down prepayment penalty clause structured as follows:
– Year 1: 5%
– Year 2: 4%
– Year 3: 3%
– Year 4: 2%
– Year 5: 1%
– Years 6 – 10: 0%
If the borrower decides to prepay the loan in Year 3, and the outstanding loan balance is $900,000 at that time, the penalty is 3% of the outstanding loan balance.
Calculation:
Outstanding balance: $900,000
Penalty rate (Year 3): 3%
Prepayment penalty: $900,000 × 0.03 = $27,000
The borrower would owe $927,000 total to pay off the loan early—$900,000 in principal and $27,000 as the penalty.
Yield Maintenance
A borrower takes out a $1 million commercial loan with a 6% fixed interest rate for 10 years. After 5 years, they choose to repay the loan early. At that point, U.S. Treasury rates for the remaining 5 years are 3%. The lender was expecting to earn 6% annually over the full 10 years, but early repayment cuts that short. Yield maintenance ensures the lender is compensated for the interest income they lose due to prepayment.
Yield Maintenance Fee (Simplified):
Interest rate spread: 6% – 3% = 3%
On $1 million, that’s $30,000 per year
Over the remaining 5 years: $150,000, typically discounted to present value using the 3% Treasury rate
The borrower must pay a yield maintenance fee of approximately $150,000, depending on the exact formula and discounting applied. This protects the lender’s expected return and makes early repayment financially neutral for them.
Yield maintenance discourages borrowers from refinancing when interest rates fall, unless the savings exceed the penalty.
Break Funding
A company takes out a $1 million fixed-rate commercial loan at 5% interest for 5 years. The lender funds this loan using market instruments that also carry a fixed return.
After 3 years, the borrower decides to repay the loan early. However, market interest rates have since fallen to 3%. If the lender reinvests the prepaid amount at current rates, they would only earn 3%, resulting in a 2% annual loss on the remaining 2 years of the loan term.
Break Funding Cost Calculation (Simplified):
- Remaining loan term: 2 years
- Annual interest loss: 2% of $1,000,000 = $20,000
- Over 2 years: $40,000 (undiscounted)
The lender charges a break funding fee of approximately $40,000, possibly adjusted for present value, to compensate for this shortfall. This fee ensures the lender is financially “made whole” despite the early repayment, maintaining their expected return as if the loan were paid through full term.
Defeasance
See: Defeasance for more information and example.