Understanding Prepayment Penalties
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What Are Prepayment Penalties?
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.
Defeasance in multifamily finance is the replacement of a loan’s collateral with securities (or similar financial instruments) specifically chosen to provide a lender with an equivalent return to what they would have made from the borrower’s monthly interest payments over the full course of the loan.
Learn more about Defeasance
Yield maintenance is a much simpler prepayment penalty in which a borrower must pay the difference between the interest rate on the loan, and the standing market interest rate on the prepaid capital up to the loan’s maturity date.
Learn more about Yield Maintenance
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