Commercial Loan Prepayment Penalties Explained

What Are Commercial Loan Prepayment Penalties and Why Do They Exist?

Commercial loan prepayment penalties are fees charged by lenders when a borrower pays off a commercial mortgage before its scheduled maturity date. Understanding commercial loan prepayment penalties is essential for any commercial real estate investor planning an exit strategy, refinance, or property sale, because these fees can range from $20,000 to over $500,000 on a typical $2 million loan.

Unlike residential mortgages, where federal regulations have largely eliminated prepayment penalties, commercial loans almost always include some form of prepayment restriction. When lenders originate a commercial loan, they commit capital at a specific interest rate for a defined period. Early payoff forces the lender to reinvest those funds at potentially lower rates. The prepayment penalty compensates for that reinvestment risk. This is especially critical for securitized products like CMBS and conduit loans, where bond investors rely on predictable mortgage payment streams.

Borrowers encounter these penalties most frequently when refinancing for lower rates, selling before maturity, paying down debt with other investment proceeds, or restructuring a portfolio. Before signing any commercial mortgage, understanding prepayment terms is just as important as the interest rate itself. A low rate with a punishing penalty can cost far more than a slightly higher rate with flexible exit terms.

The five primary types are defeasance, yield maintenance, step-down (graduated) penalties, fixed percentage penalties, and hard lockout periods. Each works differently, costs differently, and applies to different loan products. Use our commercial mortgage calculator to model how prepayment terms affect your total borrowing cost.

How Does Defeasance Work on Commercial Loans?

Defeasance replaces your property as loan collateral with a portfolio of U.S. Treasury securities that generate enough cash flow to cover remaining scheduled payments. The loan continues to exist with bonds as collateral, and the lien on your property is released. You do not actually pay off the loan early.

The process involves notifying your servicer, hiring a defeasance consultant (sometimes called a successor borrower), purchasing matching Treasury securities, placing them in a trust, and obtaining your lien release. This is most commonly required on CMBS and conduit loans because the securitized payment stream must remain intact for bond investors.

Cost depends heavily on interest rates. When Treasury rates are lower than your note rate, defeasance is expensive because you must buy premium bonds to match your higher loan payments. When Treasuries yield more than your note rate, defeasance can be relatively cheap. On a $2 million loan at 5.5%, defeasance might cost $185,000 when Treasuries yield 4.0%, but only $25,000 when Treasuries yield 6.0%. This rate sensitivity makes timing a critical factor in your defeasance decision.

Additional fees of $25,000 to $50,000 cover legal counsel, accounting, servicer processing, and successor borrower costs. The process takes 30 to 45 days from start to finish. If planning a sale or refinance, request a defeasance estimate from your servicer well in advance, as quotes fluctuate daily with Treasury rates.

What Is Yield Maintenance and How Is It Calculated?

Yield maintenance compensates the lender for the interest income they would have earned over the remaining loan term. It equals the present value of the difference between your note rate and the current Treasury rate across all remaining monthly payments.

Penalty = Present Value of (Note Rate minus Treasury Rate) x Remaining Balance x Remaining Term

For each remaining payment, the formula calculates the difference between what the lender would have earned at the note rate and what they can earn by reinvesting at the current Treasury rate. Those differences are discounted to present value and summed.

Example on a $2 million loan:

• Note rate: 5.75%, Treasury rate: 4.25%, differential: 1.50%
• Remaining term: 7 years (84 months)
• Approximate penalty: $142,000

Yield maintenance is most common on agency loans (Fannie Mae/Freddie Mac multifamily), life insurance company loans, and some bank portfolio loans.

Like defeasance, yield maintenance is rate-sensitive. When rates rise above your note rate, the penalty drops toward a floor (typically 1% of balance). Many clauses include a "greater of" provision stating the penalty is the greater of the calculation or 1% of balance, ensuring minimum compensation regardless of rate movements. When reviewing loan documents, look carefully at this floor.

Yield maintenance processes in 5 to 10 business days with minimal third-party costs, making it faster than defeasance when you need to close a sale or refinance quickly.

How Do Step-Down Prepayment Penalties Work?

Step-down penalties charge a declining percentage of the outstanding balance over time according to a predetermined schedule. This is the most straightforward and predictable type, common on bank loans, bridge loans, and portfolio products.

The standard "5-4-3-2-1" structure on a 10-year loan means 5% in year 1, 4% in year 2, declining to 1% in year 5, then no penalty from year 6 through maturity. Other common schedules include 3-2-1 (shorter), 2-1 (minimal), and custom negotiated arrangements.

Dollar example on a $2 million loan with a 5-4-3-2-1 schedule:

• Year 1: $2,000,000 x 5% = $100,000
• Year 3: $2,000,000 x 3% = $60,000
• Year 5: $2,000,000 x 1% = $20,000
• Year 6+: $0

The key advantage is predictability. Step-down costs do not fluctuate with interest rates. You know exactly what the penalty will be at any point, making exit strategy planning straightforward.

Step-downs are also the most negotiable penalty type. During origination, you can often negotiate a shorter schedule like 3-2-1-0-0 instead of 5-4-3-2-1, saving tens of thousands of dollars if you sell or refinance early.

Borrowers pursuing bridge loans for value-add projects should pay close attention to step-down terms. The business plan revolves around a short-term exit, and even a 3-2-1 penalty could cost $60,000 on a $2 million loan if you exit in year 1.

What Is a Lockout Period and Can You Get Around It?

A lockout period blocks all prepayment for a defined window, regardless of how much you are willing to pay. This is the most restrictive form of prepayment protection, most common on CMBS and conduit loans, typically lasting 2 to 5 years on a 10-year term. A common structure is a 2-year lockout followed by defeasance for the remaining term.

Workarounds are extremely limited:

Loan Assumption is the primary option. The buyer takes over your existing loan, pays a 0.5% to 1.0% assumption fee, and must qualify with the servicer. This avoids prepayment entirely but requires the buyer to accept your loan terms.

Supplemental Financing adds debt on top of the locked-out loan without triggering prepayment, if the servicer allows combined leverage within acceptable limits.

Waiting is often most practical if you are 6 to 12 months from lockout expiration.

When negotiating a new conduit loan, push for the shortest lockout possible. Some lenders reduce it from 3 years to 2 years in exchange for a modestly higher spread of 5 to 15 basis points.

How Much Will Your Prepayment Penalty Actually Cost?

The actual cost depends on four variables: penalty type, outstanding balance, remaining term, and (for yield maintenance and defeasance) the current rate environment.

Real dollar examples on a $2 million loan at 5.50% with 7 years remaining:

• Defeasance: Bond portfolio costs $145,000 to $165,000. Add $25,000 to $40,000 in third-party fees. Total: $170,000 to $205,000.
• Yield Maintenance: Calculation yields $125,000 to $155,000 plus minimal processing. Total: $126,000 to $158,000.
• Step-Down (Year 3, 3%): 3% of approximately $1,920,000 balance = $57,600. No additional fees.
• Fixed 2%: 2% of $1,920,000 = $38,400. Simple and rate-independent.

The difference between defeasance and a step-down can exceed $100,000 on the same loan. This gap should influence which loan product you choose at origination, not just at payoff. Use our commercial mortgage calculator to model total costs including prepayment scenarios.

Facing a prepayment penalty now? Contact our team for a complimentary payoff analysis to determine whether refinancing makes financial sense after accounting for the penalty cost.

Which Loan Types Have the Strictest Prepayment Penalties?

CMBS and conduit loans are the strictest, combining hard lockouts with mandatory defeasance. Agency loans rank second with yield maintenance. Bank portfolio loans and bridge loans offer the most flexibility.

CMBS/Conduit: 2 to 5 year lockout plus defeasance. Almost no flexibility post-closing because terms are governed by securitization trust documents. Learn more about conduit loan structures.

Agency (Fannie/Freddie): Yield maintenance with a 1% floor and a 90-day open window before maturity. Some products offer declining prepayment alternatives.

Life Insurance Companies: Yield maintenance similar to agency, typically non-negotiable but may offer modest modifications for strong borrowers.

Bank Portfolio: Step-down schedules (5-4-3-2-1 or 3-2-1) with room to negotiate shorter schedules, lower percentages, or 10-20% annual curtailment allowances.

Bridge Loans: Lightest penalties. Minimum interest guarantees (3-6 months) or modest 1-2% exit fees. Some charge nothing. Read our guide on what is a commercial bridge loan.

SBA Loans: SBA 504 penalties decline over 10 years starting at 2.65%. SBA 7(a) charges 5%/3%/1% in years 1-3, then nothing. Penalties apply only when prepaying 25% or more of the outstanding balance annually.

How Can You Negotiate Better Prepayment Terms?

The best time to negotiate is before closing, not at payoff. Once documents are signed, modifications are nearly impossible. At origination, borrowers with strong profiles have meaningful leverage.

Six proven strategies:

1. Request step-down instead of yield maintenance. Banks often accommodate this for borrowers with strong credit, significant deposits, or ongoing banking relationships.

2. Negotiate shorter lockout periods. Accept 5 to 15 basis points higher spread for a 2-year lockout instead of 3 to 5 years. This tradeoff is often worthwhile for borrowers planning exits within 5 to 7 years.

3. Include partial prepayment allowances. Request 10-20% annual curtailment without penalty. This is one of the easiest concessions to obtain and significantly reduces future penalty exposure over time.

4. Add an open window or rate reset clause. Negotiate penalty-free prepayment around midterm rate reset dates, creating a natural exit point.

5. Ensure loan assumption provisions. Confirm assumability and a clearly defined qualification process for buyers. This creates an exit path during lockout periods.

6. Leverage competing term sheets. Obtain multiple offers and use them to negotiate improved prepayment flexibility as part of the overall package.

On a $3 million loan, the difference between step-down and yield maintenance could exceed $75,000 in year 3. Need help? Contact Clear House Lending for guidance on structuring optimal terms.

When Does It Make Financial Sense to Pay the Penalty?

Paying makes sense when refinancing savings, sale profits, or strategic positioning exceeds the total penalty plus transaction costs. Run a break-even analysis.

Refinancing example: $2 million loan at 7.25% with a $95,000 yield maintenance penalty. Refinancing at 5.75% saves $30,000 per year in interest. Break-even: 3.2 years. If holding 5+ years after refinancing, net benefit exceeds $55,000. Factor in $25,000 to $40,000 in refinancing costs for a complete picture. Use our DSCR calculator to verify new loan qualification.

Sale example: Selling for $500,000 profit with a $120,000 penalty leaves $380,000 net. Often worth taking if market conditions favor sellers or a better investment opportunity is waiting.

1031 Exchange timing: If lockout or defeasance timelines threaten your 45/180-day exchange deadlines, paying a larger penalty may preserve hundreds of thousands in deferred capital gains taxes.

2026 rate environment: With rates elevated compared to 2020-2021 loan originations, many borrowers are finding yield maintenance and defeasance penalties far lower than expected. Request a current payoff quote from your servicer to check.

Ready for a detailed analysis? Schedule a free consultation with our team for a cost-benefit breakdown of your specific prepayment scenario.

What Happens to Prepayment Penalties When You Sell the Property?

When selling, you either pay off the loan (triggering the penalty) or arrange for the buyer to assume it.

Loan payoff is most common. The penalty is deducted from sale proceeds at closing. On a $3.5 million sale with a $2.2 million balance and $95,000 penalty, gross proceeds drop to $1,205,000 before other closing costs.

Loan assumption avoids the penalty entirely. The buyer applies to the servicer, pays a 0.5-1.0% assumption fee ($11,000 to $22,000 on $2.2 million), and takes over your loan terms. This is vastly cheaper than a $95,000+ penalty.

Assumption can actually increase your sale price when your loan carries a below-market rate. A buyer assuming a 4.5% loan in a 6.5% rate environment receives financing worth tens of thousands annually, and smart sellers price this benefit into the deal. Explore our guide on commercial loan down payment requirements for more on buyer equity considerations.

How Do Prepayment Penalties Differ for Refinancing vs Sale?

The penalty amount is identical for either scenario since it is triggered by loan payoff. However, the strategic calculus and available workarounds differ significantly.

Refinancing gives you more timing control. If your penalty is rate-sensitive (yield maintenance or defeasance), you can wait for a favorable rate environment. You can also use annual curtailment provisions to reduce your balance before eventually refinancing the remainder. Many borrowers refinance through agency or conduit products to lock in lower rates or extract equity.

Sale timing is often driven by market conditions or buyer availability rather than penalty optimization. The loan assumption option is most valuable in a sale context because it completely eliminates the penalty while potentially increasing your sale price in rising rate environments where your existing rate is below market.

Tax treatment also differs: Refinance penalties are generally deductible as interest expense over the remaining old loan or new loan term. Sale penalties may reduce taxable capital gains. In 1031 exchanges, penalties affect boot calculations and exchange equity requirements. Consult your tax advisor for specifics.

Frequently Asked Questions About Commercial Loan Prepayment Penalties?

What is the most common prepayment penalty on commercial loans? Step-down penalties are most common overall on bank portfolio loans. For loans above $5 million, defeasance (CMBS) and yield maintenance (agency) are more prevalent.

Can you deduct a prepayment penalty on your taxes? Yes, in most cases. Commercial investment property penalties are generally deductible as a business expense. Consult a qualified tax professional for your specific situation.

How do you avoid prepayment penalties on commercial loans? Negotiate favorable terms at origination: shorter step-downs, partial prepayment allowances, and open windows. After closing, wait for the penalty to expire, use loan assumption, or time your payoff during a rising rate environment.

Do bridge loans have prepayment penalties? Most bridge loans have minimal penalties: 3-6 month minimum interest guarantees or small exit fees. Some charge nothing. See our guide on what is a commercial bridge loan.

What is the difference between a soft prepayment penalty and a hard lockout? A soft penalty lets you prepay by paying a calculated fee (defeasance, yield maintenance, or step-down). A hard lockout blocks all prepayment regardless of willingness to pay. Hard lockouts are most common on CMBS loans, lasting 2 to 5 years.

How long does defeasance take to process? Typically 30 to 45 days, including servicer notification, consultant engagement, Treasury purchase, legal documentation, and lien release. Build this timeline into any property sale agreement.

Can you negotiate a prepayment penalty after the loan closes? Extremely difficult. Bank portfolio lenders may rarely agree if you bring significant new business or deposits. CMBS modifications are virtually impossible since trust documents govern the terms.

Does paying a prepayment penalty affect your credit? No. The loan is reported as paid in full, which is a positive credit event.

Sources: Federal Reserve Commercial Lending Survey (2025), Mortgage Bankers Association Commercial/Multifamily Lending Report, Trepp CMBS Research, Fannie Mae Multifamily Lending Guidelines, Freddie Mac Optigo Seller/Servicer Guide, SBA Standard Operating Procedures (SOP 50 10), Commercial Real Estate Finance Council (CREFC), American Bar Association Real Property Section.