Prepayment Penalties: Defeasance, Yield Maintenance & Step-Downs

Why Commercial Loans Have Prepayment Penalties

Unlike residential mortgages, commercial loans almost always carry prepayment penalties. Understanding why they exist helps you negotiate better terms and plan your exit strategy from the start.

Reason 1: Protecting the Lender's Expected Yield

When a lender originates a commercial loan at 7.5% for 10 years, they have priced that loan based on receiving 10 years of interest payments. If you prepay after 3 years because rates dropped, the lender must reinvest at a lower rate and loses the expected yield. The prepayment penalty compensates for this lost income.

Reason 2: Recovering Origination Costs

Commercial loans carry significant origination costs---underwriting staff, legal fees, appraisals, environmental reports, and compliance reviews. These costs are amortized over the expected loan life. Early prepayment means the lender did not recover those costs from the interest spread.

Reason 3: Securitization Requirements (CMBS)

For loans that have been securitized into commercial mortgage-backed securities (CMBS), investors purchased bonds based on projected cash flows. Prepayment disrupts those cash flows and reduces investor returns. Defeasance and yield maintenance exist specifically to protect CMBS bondholders.

Type 1: Defeasance

How Defeasance Works

Defeasance does not pay off the loan early. Instead, it replaces the real estate collateral with a portfolio of U.S. Treasury securities whose cash flows exactly match the remaining loan payment schedule. The loan continues to exist on paper, the CMBS trust continues to receive its scheduled payments, and the borrower is released from the mortgage.

The defeasance process in detail:

1. The borrower notifies the loan servicer of intent to defease (typically 30-60 days notice required)
2. A defeasance consultant calculates the exact portfolio of Treasury securities needed to match every remaining payment
3. The borrower purchases the Treasury portfolio through a securities intermediary (typically a bank trust department)
4. A successor borrower (usually a special-purpose entity set up by the defeasance consultant) assumes the defeased loan
5. The original borrower receives a release of the mortgage lien and is free to sell or refinance the property

Lockout Period

Most CMBS loans and some portfolio loans have a 24-36 month lockout period during which no prepayment---not even defeasance---is permitted. A typical structure might be "2 years lockout, then defeasance permitted for years 3-9, then open for the final 90 days."

Cost of Defeasance

Defeasance cost depends entirely on the spread between your loan rate and current Treasury yields at the time you defease. The math:

• If Treasuries yield LESS than your loan rate (rates have fallen): Defeasance is expensive because you must purchase more Treasuries to generate enough cash flow to cover higher loan payments. This is the most common scenario for borrowers wanting to defease---they want to refinance precisely because rates have dropped.
• If Treasuries yield MORE than your loan rate (rates have risen): Defeasance is cheap because fewer Treasury dollars are needed to match payments. But in this scenario, you have little incentive to defease since refinancing at a higher rate makes no sense.

Additional fixed costs include the defeasance consultant fee ($25,000-$75,000), legal fees ($15,000-$30,000), securities intermediary fee, and rating agency fees if applicable. Total transaction costs typically range from $50,000-$150,000 before the Treasury portfolio cost.

Type 2: Yield Maintenance

How Yield Maintenance Works

Yield maintenance is a cash penalty calculated to make the lender economically whole---as if the loan were never prepaid. You pay a lump sum equal to the present value of the remaining interest payments that the lender will forgo, discounted at a rate tied to current Treasury yields.

Yield Maintenance Formula

The formula varies by loan document, but the standard approach is:

Penalty = Present Value of (Loan Rate - Treasury Rate) x Remaining Balance x Remaining Term

Worked Example: $5M Loan

Assume:

• Original loan: $5,000,000 at 7.25% fixed for 10 years
• Prepaying after year 4 (6 years remaining)
• Current outstanding balance: $4,350,000
• Current 6-year Treasury yield: 4.25%
• Rate differential: 7.25% - 4.25% = 3.00%

Simplified calculation:

Annual interest differential: $4,350,000 x 3.00% = $130,500 per year

Present value of $130,500 per year for 6 years at 4.25% discount rate:

In this example, the yield maintenance penalty would be approximately $678,548 (13.5% of the outstanding balance). The actual calculation accounts for monthly amortization and the declining balance, but this illustrates the magnitude.

Key Characteristics of Yield Maintenance

• The penalty increases when rates fall (the spread widens, making the present value of lost interest higher)
• The penalty decreases when rates rise (the spread narrows or goes to zero; most loan documents have a floor of 1% or the minimum of the calculated amount and 1%)
• Many loan documents specify the penalty is the greater of the yield maintenance calculation or 1% of the outstanding balance
• Yield maintenance is more common in portfolio loans from banks, life companies, and credit unions

Type 3: Step-Down (Declining Prepayment Penalty)

How Step-Down Penalties Work

A step-down penalty is the simplest structure: a fixed percentage of the outstanding balance that declines over time according to a predetermined schedule. No complex calculations, no dependence on interest rates.

Common Step-Down Schedules

5-4-3-2-1 (Five-Year Step-Down): 3-2-1 (Three-Year Step-Down): ### Advantages of Step-Down Penalties

• Predictable costs: You know the exact penalty amount at any point during the loan term
• Not affected by interest rate movements: Unlike yield maintenance and defeasance, the cost is fixed regardless of where rates go
• Lower cost in falling rate environments: When rates drop significantly, step-down penalties are often much cheaper than yield maintenance
• Simpler to negotiate: The schedule is straightforward and easy to compare across lenders

Comparison: All Three Penalty Types

## Which Loan Types Have Which Penalties ## How to Negotiate Better Prepayment Terms

Strategy 1: Negotiate a Step-Down Instead of Yield Maintenance

If the lender initially proposes yield maintenance, ask for a step-down alternative. Many portfolio lenders have flexibility on this point, especially for borrowers with strong credit profiles and competitive deals. A step-down gives you cost certainty and protects you in falling-rate environments.

Strategy 2: Negotiate a Shorter Lockout Period

CMBS lockout periods are largely non-negotiable, but bank portfolio lockout periods often are. Push for 12 months instead of 24, or request no lockout at all with a step-down penalty starting from day one.

Strategy 3: Request an Open Prepayment Window

Ask for the loan to be fully open (no penalty) for the last 6-12 months of the term instead of just the last 90 days. This gives you significantly more flexibility to time a refinance or sale.

Strategy 4: Negotiate a Lower Step-Down Schedule

Counter a 5-4-3-2-1 with a 3-2-1 or a 4-3-2-1-0 (open in year 5). Even saving 1-2 percentage points on the schedule can save tens of thousands of dollars if you need to exit early.

Strategy 5: Include a Rate-Match Exception

Negotiate a clause that waives the prepayment penalty if you refinance with the same lender at then-current market rates. This incentivizes the lender to offer competitive refinance terms and gives you a penalty-free exit path.

Strategy 6: Request a Partial Prepayment Allowance

Many loans permit you to prepay 10-20% of the original balance per year without penalty. If the loan does not include this feature, negotiate it in. Partial prepayment reduces your balance and interest cost over time without triggering the full penalty.

Frequently Asked Questions

Can I include prepayment penalty costs in my refinance loan?

In most cases, no. The prepayment penalty must be paid in cash at the time of payoff. However, some lenders will allow you to finance the penalty into the new loan if the resulting LTV is still within their guidelines. This is more common with bridge lenders and private capital sources.

Do prepayment penalties apply if I sell the property?

Yes. The prepayment penalty applies regardless of the reason for payoff---refinance, sale, or voluntary prepayment. Some CMBS and portfolio loans offer an assumability option where the buyer takes over the existing loan, avoiding the penalty entirely. Loan assumption requires lender approval and the buyer must meet underwriting standards.

How do I calculate defeasance cost before committing?

Contact a defeasance consultant (Chatham Financial, Derivative Logic, and AST Defeasance are well-known firms) for a preliminary cost estimate. They can run the Treasury portfolio calculation in 24-48 hours using current market rates. The estimate is free or low-cost and gives you a realistic number before you commit to the transaction.

Is there a way to avoid prepayment penalties entirely?

Certain loan products carry no prepayment penalty: floating-rate bridge loans (sometimes), lines of credit, most construction loans after completion, and some credit union commercial loans. If prepayment flexibility is critical to your strategy (e.g., you plan to sell or refinance within 2-3 years), prioritize loan products with no penalty or short step-down schedules, even if the rate is slightly higher.

What is "par prepayment" and when does it apply?

Par prepayment means paying off the loan at the outstanding balance with no penalty. Most commercial loans have a par prepayment window---typically the last 90 days before maturity. Some loans also allow par prepayment if the lender declines to renew or extend the loan at maturity. Check your loan documents for the specific par window.

How does prepayment penalty interact with loan assumption?

If your loan is assumable and a qualified buyer assumes the loan, no prepayment occurs---the loan stays in place with a new borrower. The original prepayment penalty terms transfer to the new borrower. Assumption fees are typically 0.5-1% of the outstanding balance, which is almost always cheaper than any prepayment penalty. CMBS loans are generally assumable; bank portfolio loans are generally not.

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Planning an exit strategy? Understanding prepayment terms is critical before you close. Check current rates on FundedDeal, start your application with lenders who offer flexible prepayment terms, or learn more about bridge loans for short-term financing needs.