A step-down (or declining or graduated) prepayment penalty is a prepayment risk mitigation tool employed by lenders in Commercial Real Estate Loans. To insure against the loss of interest earnings during a loan’s full term, commercial mortgage lenders may include a step-down clause in a mortgage contract. Generally, this is a straightforward declining payment schedule based on the remaining balance at prepayment in conjunction with the amount of time passed since the loan was closed (or the last occurrence of a rate reset). The step-down prepayment penalty gets its name from the gradual reduction of the penalty as a loan matures.

Though there are many configurations of step-down schedules, an example of a typical step-down penalty structure is the 5-4-3-2-1 schedule, which, for a 5 year loan term, makes the borrower responsible for paying a penalty of 5% of the outstanding balance if prepaying the loan in the first year, 4% in the second year, 3% in the third year, and so on. Another common step-down structure for a five-year loan term is the 3-1-1, which only penalizes the borrower if the debt is prepaid within the first three years of the term. Many lenders do not impose a step-down penalty in the last 90 days of a loan term.

A step-down (or declining or graduated) prepayment penalty is a prepayment risk mitigation tool employed by lenders in Commercial Real Estate Loans. To insure against the loss of interest earnings during a loan’s full term, commercial mortgage lenders may include a step-down clause in a mortgage contract. Generally, this is a straightforward declining payment schedule based on the remaining balance at prepayment in conjunction with the amount of time passed since the loan was closed (or the last occurrence of a rate reset). The step-down prepayment penalty gets its name from the gradual reduction of the penalty as a loan matures.

Though there are many configurations of step-down schedules, an example of a typical step-down penalty structure is the 5-4-3-2-1 schedule, which, for a 5 year loan term, makes the borrower responsible for paying a penalty of 5% of the outstanding balance if prepaying the loan in the first year, 4% in the second year, 3% in the third year, and so on. Another common step-down structure for a five-year loan term is the 3-1-1, which only penalizes the borrower if the debt is prepaid within the first three years of the term. Many lenders do not impose a step-down penalty in the last 90 days of a loan term.

The main benefit of a step-down prepayment penalty is that it provides lenders with a risk mitigation tool to protect against the loss of interest earnings during a loan’s term. This type of penalty structure also provides borrowers with more flexibility in terms of prepayment, as the penalty decreases as the loan matures. Additionally, many lenders do not impose a step-down penalty in the last 90 days of a loan term.

The main drawback of a step-down prepayment penalty is that it can be expensive for borrowers. If a borrower needs to prepay the loan before the end of the term, they may be subject to a large penalty. Additionally, the penalty may be higher than the amount of interest the lender would have earned if the loan had been paid off at the end of the term. This can be especially true if the loan is prepaid in the early years of the term.

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Source: https://www.multifamily.loans/apartment-finance-blog/step-down-prepayment-penalty-demystified/

The alternatives to a step-down prepayment penalty are Defeasance and Yield Maintenance. Learn more about Defeasance and Yield Maintenance.