Prepayment penalties: what they are and when they apply
Key takeaways
04 · ideas- Hard prepayment penalties apply whether you sell, refinance, or pay cash
- Soft penalties apply only to refinancing, not to sale
- Qualified Mortgage loans have restricted prepayment penalty structures
- Commercial real estate loans often use yield maintenance provisions
Basic level
The essentials · 1 min
A prepayment penalty is a fee charged when a borrower pays off all or a significant portion of a loan earlier than scheduled.
Why lenders charge them: Lenders earn revenue from interest over the loan term. When a borrower pays off early — particularly by refinancing to a competing lender — the original lender loses anticipated interest income. Prepayment penalties compensate for this.
Two types:- Hard prepayment penalty: Applies for any reason — sale, refinancing, or paying cash
- Soft prepayment penalty: Applies only to refinancing; not triggered by property sale
Intermediate level
How it applies · 1 min
How they are calculated
Common structures:- Percentage of remaining balance: e.g., 2% in year 1-2, 1% in year 3
- Step-down: e.g., 5% in year 1, 4% in year 2, 3% in year 3 (common in commercial real estate)
- Yield maintenance: Compensates for the difference between the loan rate and current Treasury rates (used in commercial mortgage-backed securities)
Example: $300,000 mortgage with a 2% prepayment penalty in years 1-3. Refinancing after 2 years costs $5,400 in penalties, which must be weighed against the savings from the new rate.
Where they appear
Residential mortgages: Less common on conventional loans since Dodd-Frank (2014) restricted prepayment penalties on Qualified Mortgages. Still appear on non-QM loans, hard money loans, and some ARMs.
Commercial real estate: Prepayment penalties are common on commercial mortgages, often with significant financial impact.
Advanced level
The math, step by step · 1 min
Yield maintenance
Yield maintenance is used primarily in CMBS:
In a declining rate environment, yield maintenance produces substantial penalties because the rate differential is large. In a rising rate environment, if Treasury yields exceed the loan rate, yield maintenance may produce zero penalty.
Defeasance is an alternative: the borrower substitutes government securities into the trust that generate cash flows equivalent to remaining loan payments, effectively terminating the obligation without a lump-sum prepayment.