What is a prepayment penalty on a commercial mortgage?

What is a Prepayment Penalty?

Prepayment penalties (or prepay penalties) are fees charged for early loan repayment, with several types including Yield Maintenance, Defeasance, and Step-Down penalties. Yield Maintenance and Defeasance ensure lenders receive expected interest income, while Step-Down penalties decrease the fee over time. Other forms like Lockout Periods, Flat Prepayment, and Interest Guarantees vary in structure, offering different implications for borrowers' financial strategies.

Types of Prepayment Penalties

There are several different types of prepayment penalties that you might encounter in multifamily loans:

1. Yield Maintenance: This penalty allows the lender to receive an amount that would equal the net present value of the remaining interest payments that would have been paid if the loan had not been prepaid. It's designed to make the lender indifferent to whether the borrower pays off the loan early or not.
2. Defeasance: Similar to yield maintenance, defeasance is a process where the borrower replaces the original collateral (the property) with other collateral - typically securities like government bonds - that will provide the lender with the same amount of income as the original loan would have.
3. Step-Down (or Graduated) Prepayment Penalty: This is a pre-determined schedule in the loan agreement that reduces the prepayment penalty over time. For example, a common structure is a 5-4-3-2-1 step-down, where the prepayment penalty is 5% of the outstanding balance if prepaid in the first year, 4% in the second year, and so on.
4. Lockout Period: Under this type of penalty, the borrower is prohibited from paying off the loan for a certain period of time after the loan is originated. After the lockout period expires, a different type of prepayment penalty might apply.
5. Flat Prepayment Penalty: This is a fixed percentage of the loan balance regardless of when the loan is paid off before its maturity date.
6. Interest Guarantee: The borrower must pay a certain amount of interest regardless of when the loan is paid off. This is similar to yield maintenance but may be structured slightly differently.
7. Soft Prepayment Penalty: This only applies if the property is sold during the penalty period. If the borrower refinances, they do not have to pay the prepayment penalty.
8. Breakfunding Fee: This is less common but can be found in some adjustable-rate loans. It compensates the lender for the administrative costs and potential loss of income due to the early repayment of the loan.

Each type of prepayment penalty has its own implications for borrowers, and the choice of which one to agree to (or negotiate out of a loan agreement) depends on the borrower's financial strategy, the specific terms of the loan, and market conditions.