Every commercial real estate loan comes with a cost for paying it off early. These prepayment penalties exist because lenders build their returns around the assumption that you will make payments for the full loan term. When you refinance or sell before maturity, the lender loses anticipated interest income. According to the Mortgage Bankers Association, more than $957 billion in commercial and multifamily mortgages are set to mature through 2026, meaning hundreds of thousands of borrowers will encounter prepayment provisions as they plan their exit strategies.

The four primary prepayment penalty structures in commercial real estate are defeasance, yield maintenance, step-down penalties, and flat penalties. Each has a dramatically different cost profile. A borrower who pays off a $10 million CMBS loan in year three might face $500,000 or more in defeasance costs, while a borrower with a bank loan using a step-down schedule might pay $300,000. Understanding these differences before you sign a term sheet can save you hundreds of thousands of dollars.

Whether you are evaluating a refinance, planning to sell, or negotiating new loan terms, this guide covers every prepayment penalty type, their real costs, and how to negotiate more favorable terms.

Need help evaluating your prepayment options? Talk to our lending team today.

What Are the Four Types of Prepayment Penalties on Commercial Loans?

Commercial mortgage prepayment penalties fall into four categories: defeasance, yield maintenance, step-down (also called declining balance), and flat percentage penalties. Each structure calculates the cost differently, and the penalty you face depends primarily on the type of lender and loan product you choose.

Defeasance is the most complex and often the most expensive. It requires borrowers to purchase a portfolio of U.S. Treasury securities that replicate the remaining loan payment schedule, effectively replacing the property as collateral. Yield maintenance calculates the present value of the lender's lost interest income based on the difference between your loan rate and current Treasury yields. Step-down penalties apply a fixed percentage that declines over the loan term, typically following a schedule such as 5-4-3-2-1. Flat penalties charge a simple percentage of the outstanding balance, usually between 1% and 3%.

The loan type largely dictates which penalty structure applies. CMBS conduit loans almost always require defeasance or yield maintenance. Agency loans from Fannie Mae and Freddie Mac use yield maintenance or defeasance. Bank portfolio loans typically offer the most flexible terms, including step-down and flat penalties. Life insurance company loans often use yield maintenance. Bridge loans and private money loans frequently have little or no prepayment penalty, which is one reason they carry higher interest rates.

How Does Defeasance Work and What Does It Cost?

Defeasance replaces the property securing your loan with U.S. Treasury securities that generate the same cash flow as your remaining mortgage payments. The process costs between 3% and 10% of the outstanding loan balance, depending on interest rates, remaining term, and market conditions. When interest rates are lower than your loan rate, the cost of purchasing sufficient Treasuries increases because those securities generate less income per dollar invested.

The defeasance process requires hiring a defeasance consultant, a securities intermediary, and legal counsel. According to Chatham Financial, administration fees alone typically run 0.5% of the loan balance. On top of that, you must fund the purchase of the replacement securities. A successor borrower entity, usually a special-purpose LLC, assumes the remaining loan obligation while holding the Treasury portfolio until maturity.

Defeasance applies almost exclusively to securitized loans. CMBS conduit loans, Fannie Mae DUS loans, and Freddie Mac loans commonly require it as the only prepayment option. According to data from CRED iQ, defeasance activity in the CMBS market has fluctuated significantly with interest rate movements, peaking during periods of low Treasury yields when borrowers rush to lock in refinancing savings despite higher defeasance costs.

One important consideration: defeasance can actually become cheaper when interest rates rise. If Treasury yields exceed your loan interest rate, the cost of purchasing replacement securities drops because those bonds generate more income relative to your required debt service payments.

How Does Yield Maintenance Differ From Defeasance?

Yield maintenance is a prepayment penalty that compensates the lender for lost interest income by calculating the present value of the difference between your loan's interest rate and the current Treasury yield for the remaining loan term. The typical cost ranges from 2% to 8% of the outstanding balance, though it can exceed this range in extreme rate environments. According to CommLoan, yield maintenance ensures lenders receive the same return they would have earned had the borrower kept the loan to maturity.

The basic formula is: Yield Maintenance = Present Value of Remaining Payments multiplied by (Loan Interest Rate minus Treasury Rate). For example, if you have a $10 million loan at 6.5% interest with 60 months remaining, and the current 5-year Treasury yield is 4.2%, the yield maintenance penalty compensates the lender for the 2.3% annual interest rate differential across those remaining payments, discounted back to present value.

The critical variable in yield maintenance is the interest rate environment. When rates drop significantly below your loan rate, the penalty becomes very expensive because the lender is losing more income by having to reinvest at lower rates. Conversely, when rates rise above your loan rate, yield maintenance penalties can shrink to near zero, because the lender can reinvest at a higher rate than your original loan was providing.

Yield maintenance is common in agency multifamily loans, life insurance company loans, and some CMBS transactions. Unlike defeasance, yield maintenance is a straightforward cash payment. You do not need to hire a defeasance consultant, purchase Treasury securities, or create a successor borrower entity. This makes the process faster and simpler, typically completing in days rather than the 30 to 45 days defeasance requires.

Use our commercial mortgage calculator to model how different interest rate scenarios affect your total loan costs, including potential prepayment penalties.

What Is a Step-Down Prepayment Penalty and How Is It Structured?

A step-down prepayment penalty starts at a higher percentage and declines over the loan term, following a predetermined schedule written into your loan documents. The most common structure is a 5-4-3-2-1 schedule, meaning you pay 5% of the outstanding balance if you prepay in year one, 4% in year two, and so on until the penalty drops to 1% in year five. Most lenders waive the penalty entirely in the final 90 days of the loan term.

Step-down penalties are the most borrower-friendly of the major prepayment structures because the cost is predictable and transparent. Unlike defeasance or yield maintenance, the penalty amount does not fluctuate with interest rates or require complex calculations. On a $10 million loan in year three of a 5-4-3-2-1 schedule, the penalty is exactly $300,000 (3% of the balance), regardless of where Treasury yields stand.

Bank portfolio loans are the most likely to offer step-down penalty structures. Credit unions, community banks, and regional banks often use step-down schedules because they hold these loans on their own balance sheets rather than securitizing them. This gives them more flexibility to offer borrower-friendly terms, especially for relationship borrowers with strong deposit accounts or multiple loans with the same institution.

Variations exist beyond the standard 5-4-3-2-1. Some lenders offer a 3-2-1 schedule for shorter-term loans or a softer 4-3-3-2-2-1 schedule for longer terms. The key negotiation point is the starting percentage and how quickly the penalty declines.

How Do Prepayment Costs Compare Across a $10 Million Loan?

On a $10 million commercial loan prepaid in year three, the penalty ranges from $100,000 with a flat 1% structure to $700,000 or more with defeasance, depending on market conditions. This seven-to-one cost difference demonstrates why understanding your prepayment options before signing the loan is critical.

Consider a concrete scenario: a borrower took out a $10 million, 10-year commercial loan at 6.5% interest. After three years, they want to sell the property. The outstanding balance is approximately $9.5 million. Under defeasance, the borrower might pay $475,000 to $950,000 to purchase replacement Treasuries and cover consultant fees. Under yield maintenance, the penalty depends entirely on current rates. If 7-year Treasury yields sit at 4.0%, the yield maintenance penalty could reach $600,000 or more. Under a 5-4-3-2-1 step-down, the year-three penalty is exactly $285,000 (3% of $9.5 million). Under a flat 1% penalty, the cost is just $95,000.

These numbers underscore a fundamental truth in commercial lending: the cheapest interest rate does not always mean the cheapest loan. A CMBS loan at 5.8% with defeasance requirements might cost far more over the hold period than a bank loan at 6.2% with a step-down penalty, especially if the borrower plans to sell or refinance before maturity.

What Are Lockout Periods and How Do They Affect Prepayment?

A lockout period is a window at the beginning of a commercial loan during which the borrower cannot prepay the loan under any circumstances, regardless of willingness to pay a penalty. Most CMBS conduit loans include lockout periods of two to five years, according to CMBS.loans. During this time, selling the property typically requires the buyer to assume the existing loan rather than the seller paying it off.

Lockout periods exist because CMBS loans are packaged into securities sold to investors. Those investors expect a predictable cash flow stream for a minimum period. Early prepayment, even with a penalty, would disrupt the structured payment schedule that bondholders rely on.

Recent market data shows an important shift. According to Penn Mutual Asset Management, by late 2025, 69% of new CMBS conduit deals were backed by 5-year loans rather than the traditional 10-year structure. This shift has compressed lockout periods, with the average duration of CMBS investment-grade loans falling from 5.1 years in 2019 to 3.6 years. Shorter loan terms naturally mean shorter lockout periods, giving borrowers more flexibility to exit.

Agency loans from Fannie Mae and Freddie Mac may also include lockout periods, though they are typically shorter (6 to 12 months). Bank portfolio loans rarely include hard lockout provisions, instead relying on step-down or flat penalties from day one.

Which Loan Types Have the Most Favorable Prepayment Terms?

Bridge loans and private money loans typically offer the most flexible prepayment terms, often with no penalty after the first 6 to 12 months. Bank portfolio loans come next, usually offering step-down or flat penalties that are predictable and relatively affordable. CMBS and agency loans carry the strictest prepayment provisions, including lockout periods followed by defeasance or yield maintenance requirements.

The trade-off is straightforward: loans with stricter prepayment penalties typically offer lower interest rates and longer fixed-rate terms. A 10-year CMBS loan at 5.75% with a two-year lockout and defeasance requirement will have a lower rate than a bank loan at 6.50% with a 3-2-1 step-down penalty. The question for borrowers is whether the interest rate savings over their expected hold period outweigh the potential prepayment costs if their plans change.

Life insurance company loans occupy a middle ground. They typically use yield maintenance as the prepayment mechanism, which can be expensive in falling-rate environments but reasonable when rates are stable or rising. Life company loans often offer competitive fixed rates and longer terms (10 to 30 years), making them attractive for borrowers with long hold horizons.

For a detailed look at how to evaluate and compare these term sheet provisions, understanding the prepayment structure is one of the most important elements beyond the interest rate.

How Can Borrowers Negotiate Better Prepayment Terms?

Borrowers can negotiate prepayment penalties most effectively at the term sheet stage, before the loan closes. According to Liff, Walsh & Simmons, common negotiation strategies include shortening the penalty period, reducing the starting percentage, adding an open prepayment window before maturity, or switching to a less restrictive penalty type.

The five most effective negotiation tactics are:

Request an open window before maturity. Almost all commercial loans balloon at maturity, requiring refinancing. If your prepayment penalty extends through the maturity date, you will pay a penalty simply to refinance a maturing loan. Negotiate a penalty-free window of three to six months before maturity to avoid this trap.

Negotiate the penalty type. If a lender initially proposes yield maintenance, ask whether a step-down penalty is available, even if it means accepting a slightly higher interest rate. The predictability and typically lower cost of a step-down may save more money than the rate difference costs.

Shorten the penalty period. On a 10-year loan, see if the lender will agree to a penalty that expires after year seven, leaving three years of open prepayment.

Leverage competing offers. When you have term sheets from multiple lenders, use the most favorable prepayment terms from one offer to negotiate with your preferred lender. Lenders are often willing to match competitors on prepayment provisions to win the deal.

Consider partial prepayment provisions. Some loans allow partial prepayment of 10% to 20% of the balance per year without penalty. This can significantly reduce your outstanding balance and limit the penalty amount if you do eventually prepay the full loan.

Ready to negotiate better loan terms? Our team can help structure the right prepayment provisions for your deal.

What Should Borrowers Know About CMBS Prepayment Specifically?

CMBS conduit loans carry the most restrictive prepayment provisions in commercial real estate, typically combining a two-to-five-year lockout period followed by defeasance or yield maintenance for the remainder of the term. According to the SEC, CMBS issuance has rebounded significantly, meaning more borrowers are navigating these complex prepayment structures.

The CMBS prepayment process involves the loan servicer, special servicer (if the loan is in special servicing), a defeasance consultant, and legal counsel. The borrower cannot negotiate the prepayment terms after closing because the loan has been securitized and sold to bondholders.

One strategy for CMBS borrowers planning to sell is to structure the sale as a loan assumption rather than a payoff. The buyer assumes the existing CMBS loan, and the seller avoids the prepayment penalty entirely. Assumption fees are typically 1% of the loan balance, far less than defeasance or yield maintenance costs. However, the buyer must qualify under the loan's underwriting standards, and the process can take 60 to 90 days for servicer approval.

Frequently Asked Questions

What is a typical prepayment penalty on a commercial mortgage?

A typical prepayment penalty on a commercial mortgage ranges from 1% to 5% of the outstanding loan balance, depending on the penalty structure and how early in the term you prepay. Step-down penalties on bank loans often follow a 5-4-3-2-1 schedule, while flat penalties typically range from 1% to 3%. Defeasance and yield maintenance penalties can be significantly higher, sometimes reaching 5% to 10% of the balance when interest rates are unfavorable. The specific terms are negotiated before closing and documented in your loan agreement.

Can you negotiate a prepayment penalty on a commercial loan?

Yes, prepayment penalties on commercial loans are negotiable, particularly with bank portfolio lenders, credit unions, and life insurance companies. The best time to negotiate is at the term sheet stage before you commit to the loan. Common negotiation outcomes include shorter penalty periods, lower starting percentages, open prepayment windows before maturity, and conversion from yield maintenance to step-down structures. CMBS loan prepayment terms are generally not negotiable after closing because the loan has been securitized. Strong borrowers with competitive loan offers, significant deposits, or repeat relationships with the lender have the most negotiating leverage.

How does yield maintenance work on a commercial loan?

Yield maintenance calculates the present value of the interest income the lender will lose if you pay off the loan early. The formula multiplies the present value of your remaining mortgage payments by the difference between your loan interest rate and the current Treasury yield for a matching term. For example, on a $5 million loan at 6.5% with 60 months remaining and a current 5-year Treasury yield of 4.0%, the lender is losing 2.5% annually. The penalty equals the present value of that 2.5% annual shortfall across 60 months. When interest rates fall below your loan rate, yield maintenance becomes more expensive. When rates rise above your loan rate, the penalty can approach zero.

Which commercial loans have no prepayment penalty?

Bridge loans, hard money loans, and some short-term private money loans frequently have no prepayment penalty, or they waive it after the first 6 to 12 months. Some bank portfolio loans also offer no-penalty prepayment options, particularly for adjustable-rate loans or lines of credit. SBA 7(a) loans have prepayment penalties only during the first three years (5%, 3%, 1% declining schedule). In general, shorter-term loans and floating-rate products are more likely to offer penalty-free prepayment because the lender is not locking in a fixed return over a long period.

What is a lockout period on a commercial loan?

A lockout period is a window at the start of a loan during which you cannot prepay under any circumstances, regardless of how much you are willing to pay. Lockout periods are most common in CMBS conduit loans, where they typically last two to five years. During a lockout, selling the property usually requires the buyer to assume the existing loan. After the lockout period expires, borrowers can prepay using whatever mechanism the loan documents specify, typically defeasance or yield maintenance. Bank portfolio loans rarely include lockout periods.

What is the difference between defeasance and yield maintenance?

Defeasance replaces your property as loan collateral with U.S. Treasury securities that match the remaining payment schedule, releasing the property from the mortgage lien. Yield maintenance is a cash penalty calculated as the present value of the lender's lost interest income. Defeasance typically costs 3% to 10% of the loan balance and takes 30 to 45 days to complete, requiring a defeasance consultant, securities intermediary, and legal counsel. Yield maintenance costs 2% to 8% and can be completed in days with a simple wire transfer. Defeasance applies mainly to CMBS and some agency loans. Yield maintenance appears across CMBS, agency, and life insurance company loans. In rising rate environments, defeasance may be cheaper. In stable or falling rate environments, yield maintenance may cost less.