Apartment Loan Prepayment Penalties: How Each Is Priced

Short answer

Apartment loans use four exit structures: yield maintenance, which charges the present value of the lender's lost interest measured against Treasury yields; defeasance, which replaces the property with Treasury securities that make the remaining payments; a step-down percentage of the balance; and an open window near maturity with no charge. Your note sets the formula; your servicer quotes the figure.

Four ways a loan charges you to leave

Every fixed-rate apartment loan says, in the note, what it costs to pay off early. There are four structures, and most loans use two or three of them in sequence: for example, yield maintenance, then a flat 1%, then an open window.

Structure	What you pay	Where it is common	Gets cheaper when
Yield maintenance	The present value of the interest the lender loses, measured against Treasury yields, usually with a floor	Agency fixed-rate loans, life company loans	Treasury yields rise, or time passes
Defeasance	The cost of Treasury securities that make every remaining payment, plus transaction fees	CMBS loans, securitized Freddie Mac loans	Treasury yields rise, or time passes
Step-down (declining premium)	A set percentage of the balance that falls on a schedule	Bank loans, agency loans that elect it	Time passes; rates do not matter
Open window	Nothing	The last months before maturity on most loans	Not applicable

The key difference: yield maintenance and defeasance move with the bond market, and a step-down does not. When Treasury yields are above your note rate, yield maintenance falls to its floor and defeasance can cost less than your balance. When yields are below your note rate, both get expensive.

Yield maintenance, in plain terms

Yield maintenance pays the lender the difference between your note rate and what it could earn reinvesting in Treasuries, for the rest of the yield maintenance period, discounted to today. Fannie Mae's standard prepayment schedule, in versions filed in public loan documents, is a clear example:

Find the yield rate. Interpolate the Treasury constant maturity yields published in the Federal Reserve's H.15 release for the remaining yield maintenance term, measured shortly before the prepayment date.
Take the rate gap. Your note rate minus that yield rate.
Multiply the gap by the principal you are prepaying and by a present value factor for the months left until the yield maintenance period ends.
Apply the floor. You pay the greater of that result or 1% of the principal prepaid.

After the yield maintenance period ends, the same schedule charges a flat 1%, and nothing at all from the last day of the fourth month before the maturity month. Your note may differ on any of these points: the Treasury source, the discount method, the floor, and whether the period runs to maturity or ends earlier. A period that ends six months before maturity costs less than one that runs to maturity. Read the definitions in your own note.

A hypothetical shows the scale. Say $4,000,000 is prepaid, the note rate is 1.5 points above the interpolated Treasury yield, and 36 months remain in the yield maintenance period. The premium is roughly 1.5% a year for three years on $4,000,000, discounted: a little under $170,000. If the Treasury yield were above the note rate, the formula would be negative and the 1% floor, $40,000, would apply. Run your own figures in the yield maintenance calculator.

Defeasance, in plain terms

Defeasance does not pay the loan off. It swaps the collateral. You buy a portfolio of government securities whose payments match every remaining payment on the loan, including the balloon, and the lien comes off your building. A successor entity takes over the loan and the securities.

Federal tax rules for REMIC trusts, which hold most CMBS loans, shape the mechanics: the substitute collateral must consist solely of government securities, and the release cannot happen within 2 years of the trust's startup day. That is where the common two-year lockout after securitization comes from. Freddie Mac's Conventional Small, for example, uses yield maintenance until the loan is securitized, then a 2-year lockout, then defeasance, with no premium in the final 90 days.

Your cost has two parts:

The securities. If Treasury yields are below your note rate, the portfolio costs more than your balance; if above, it can cost less.
The transaction. A defeasance consultant, servicer and legal fees, a securities intermediary, an accountant's verification and successor borrower costs. These are largely fixed, so they weigh more on a smaller loan.

Defeasance needs weeks of lead time with the servicer. Price it early with the defeasance calculator, which builds the portfolio from a Treasury curve and compares it with yield maintenance on the same loan.

Step-down schedules

A step-down charges a fixed percentage of the balance that falls over time. The math is the balance times the current percentage. Fannie Mae publishes its declining prepayment premium schedules:

Fixed-rate term	Schedule (% of balance by loan year)	Lockout
5 years	5-4-3-2-1	None
7 years	5-4-3-2-1	2 years
10 years	5-5-4-4-3-3-2-2-1-1	None

The value of a step-down is certainty. You know today what it costs to leave in any future month, whatever rates do. That is why owners who might sell or refinance mid-term often accept a higher rate for it. Freddie Mac's Conventional Small offers step-down at an additional cost.

HUD loans use lender-negotiated schedules within HUD's limits. HUD's MAP Guide generally accepts lockout and penalty structures that expire after 10 years, are no more than 10% in any of the first 10 years, and no more than 1% after that. Your rider to the note has the actual schedule.

Open windows

Most fixed-rate loans open near maturity, so you can pay off without a premium. The length depends on the program and the note: the Fannie Mae schedule above opens about four months out, and Freddie Mac's Conventional Small opens for the final 90 days. Some loans also start with a lockout, during which you cannot prepay at any price. Put the open-window date on your calendar the day you close; it anchors every refinance decision that follows.

Pay now or wait for the window

If your current rate is well above what you can get today, waiting for the open window means paying the higher rate every month you wait. The question is whether those extra months of interest cost more than the penalty plus the new loan's closing costs. Enter your balance, current rate, months until the open window, the penalty quote, the new rate and closing costs.

Refinance now or wait?

Loan balance ($)Current rate (%)Months until the open windowPrepayment cost today (% of balance)New loan rate (%)Closing costs (% of loan)Shown for reference. You pay them on either path, so they don't change the answer.

Prepayment cost today–

Interest saved per month–

Saved before the window–

Months to earn back the penalty–

Verdict–

Estimates only, not a loan quote.

Two cautions. The new rate is not guaranteed months from now, so the "wait" path carries rate risk the tool cannot price. And yield maintenance and defeasance quotes change daily with Treasury yields, so re-run the comparison when you get a fresh quote.

Getting the exact figure from your servicer

Estimates are for planning. The number you pay comes from the servicer. In order:

Identify the servicer. It is the company on your monthly statement, often not the lender that closed the loan. CMBS loans have a master servicer, and a special servicer if the loan is in trouble.
Read the note. Find the prepayment section, the required advance notice, and whether payoff is allowed only on a payment date.
Request a written payoff quote for a specific date. Ask for principal, accrued interest, the premium with its calculation, and every fee. For yield maintenance, ask which Treasury yield and pricing date were used.
For defeasance, engage early. Ask for the servicer's requirements and fee schedule, and get a consultant's estimate before you lock a new loan.
Re-quote before closing. Rate-linked premiums move daily; keep a cushion in your closing sources.

When paying the penalty still makes sense

The savings outrun the penalty before the window opens. The break-even tool above answers this.
Treasury yields are above your note rate. Yield maintenance drops to its floor, and defeasance can cost less than par.
You need the equity for a purchase or a renovation that earns more than the exit cost. See the cash-out refinance guide.
The loan has become the problem: a maturing recourse loan, a floating rate you cannot hedge cheaply, or covenants you are close to breaking.
You are selling. Check first whether a buyer can assume the loan instead; many agency loans are assumable with lender approval. See loan assumption.

Frequently asked questions

How is yield maintenance calculated on an apartment loan?

Under Fannie Mae's standard schedule, as filed in public loan documents, the premium is the greater of 1% of the principal prepaid or the principal times the gap between the note rate and an interpolated Treasury yield, times a present value factor for the months left in the yield maintenance period. After that period it is 1%, and it is zero near maturity. Your note may differ, so check its definitions.

Can defeasance cost less than my loan balance?

Yes. If current Treasury yields are higher than your note rate, the government securities needed to make your remaining payments can cost less than the outstanding balance. You still pay the consultant, servicer, legal, securities intermediary and accountant fees, so compare the all-in cost with your balance before assuming you come out ahead.

Why can't I defease my CMBS loan right after closing?

Most CMBS loans sit in REMIC trusts, and federal tax rules generally do not allow a defeased loan's lien to be released within 2 years of the trust's startup day. Loan documents reflect this with a lockout after securitization. Freddie Mac's Conventional Small, for example, uses yield maintenance until securitization, then a 2-year lockout, then defeasance.

What is a 5-4-3-2-1 prepayment penalty?

It is a step-down schedule that charges 5% of the outstanding balance if you prepay in the first loan year, 4% in the second, and so on to 1% in the fifth. Fannie Mae publishes it as its declining prepayment premium for 5-year fixed-rate loans with no lockout, and for 7-year loans after a 2-year lockout. The cost does not change with interest rates.

How do I find out my exact prepayment penalty?

Read the prepayment section of your note for the structure, period, floor and notice requirements. Then ask your loan servicer, the company on your monthly statement, for a written payoff quote for a specific date, including the premium calculation and all fees. For yield maintenance, ask which Treasury yield and pricing date it used. Re-quote close to closing, since the figure moves daily.