What is a Step-Down Prepayment Penalty?

A step-down (or declining or graduated) prepayment penalty is a prepayment risk mitigation tool employed by lenders in commercial real estate. 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.

Explore Alternative Prepayment Penalty Options:

• Learn about Defeasance
• Learn about Yield Maintenance