A prepayment penalty is a type of fee charged to a borrower who pays off a loan before the maturity date. With most commercial real estate loans, the borrower is expected to pay interest on the principal loan amount. The interest that the borrower pays represents compensation to the lender for the use of its money over a period of time, essentially dictating the lender’s rate of return. The way most commercial loans are structured, when a borrower is able to pay the loan in full ahead of schedule — without prepayment penalties in place — the lender stands to lose out on the interest that would have been earned monthly over the life of the loan.

Prepayment penalties were devised to ensure that even if a borrower were to pay their loan off at a significantly earlier point in the loan term, the lender would still receive an adequate income from the loan. In many cases, a prepayment penalty exists in the form of a single fee. In commercial real estate finance, however, with loan sums regularly in the millions, lenders typically implement one of three prepayment penalty options: defeasance, yield maintenance, or step-down prepayment.

Some loans may have a prepayment penalty, which can be costly if the borrower decides to pay off or refinance the loan early.

Prepayment penalties on apartment loans typically involve a single fee or one of three common strategies – defeasance, yield maintenance, or graduated or “step-down” prepayment. The cost of the fee will depend on the terms of the loan, and can sometimes be a significant amount of money.

A step-down, or graduated, prepayment involves a straightforward declining payment schedule — calculated based on the remaining balance at prepayment in conjunction with the amount of time that has passed since the closing of the loan or the most recent rate reset. The step-down moniker comes from the gradual reduction of the penalty borrowers are expected to pay as the loan matures.

Learn more about Step-Down Prepayment.

Prepayment penalties were devised to ensure that even if a borrower were to pay their loan off at a significantly earlier point in the loan term, the lender would still receive an adequate income from the loan. In many cases, a prepayment penalty exists in the form of a single fee. In commercial real estate finance, however, with loan sums regularly in the millions, lenders typically implement one of three prepayment penalty options: defeasance, yield maintenance, or step-down prepayment.

Defeasance is a prepayment penalty option that allows the borrower to pay off the loan without penalty, but requires them to replace the loan with a portfolio of U.S. Treasury securities. Yield maintenance is a prepayment penalty option that requires the borrower to pay a fee to the lender in order to make up for the lost interest income. Step-down prepayment is a prepayment penalty option that reduces the penalty amount over time, allowing the borrower to pay off the loan without penalty after a certain period of time.

The benefits of a prepayment penalty on an apartment loan are that it allows the lender to receive an adequate income from the loan, even if the borrower pays it off early. It also provides the borrower with options to pay off the loan without penalty, such as defeasance, yield maintenance, or step-down prepayment.

Prepayment penalties can be costly if the borrower decides to pay off or refinance the loan early. There are three common strategies for prepayment penalties - defeasance, yield maintenance, and graduated or “step-down” prepayment. With short-term bridge loans, it makes sense for investors to pay lenders back as soon as possible — a feat which typically incurs some costly penalties with traditional financing options. A good bridge loan, however, should be the opposite. It isn’t uncommon for bridge loans to be amortized, which saves investors more money the earlier the balance is paid. Even so, some bridge loans come with a factor rate that ensures that borrowers pay a set amount of interest regardless of the time of repayment. In the latter scenario, a good practice is to find out if the bridge product comes with a prepayment discount.

The drawbacks of a prepayment penalty on an apartment loan are that it can be costly if the borrower decides to pay off or refinance the loan early, and that some bridge loans come with a factor rate that ensures that borrowers pay a set amount of interest regardless of the time of repayment.

Yes, there are alternatives to a prepayment penalty on an apartment loan. Two of the most common alternatives are Defeasance and Yield Maintenance.

Defeasance is a process that allows a borrower to pay off a loan without incurring a prepayment penalty. It involves replacing the existing loan with a new loan and investing the proceeds of the new loan in a portfolio of U.S. Treasury securities. The portfolio must be structured to generate enough cash flow to pay off the existing loan.

Yield Maintenance is a type of prepayment penalty that allows a borrower to pay off a loan without incurring a penalty. It involves paying a premium to the lender in order to make up for the lost interest income that would have been earned if the loan had not been prepaid. The premium is calculated based on the difference between the interest rate on the loan and the current market rate.