Introduction
Refinancing a commercial mortgage can lower your monthly payments, reduce your rate exposure, or free capital — but prepayment penalties can wipe out those savings if you don’t plan. This guide explains the common penalty types, practical avoidance strategies, negotiation language, and real-world trade-offs I use with clients. Examples and links to deeper resources (including related FinHelp articles) are included for hands-on use.
Note: Information below is current as of 2025 and intended for educational purposes only. It is not personalized legal, tax, or lending advice. Consult your mortgage attorney or commercial mortgage broker before executing any strategy.
Sources: Consumer Financial Protection Bureau (CFPB) guidance on prepayment penalties, Investopedia definitions, and FinHelp.io resources on prepayment calculations and negotiating exit fees (see linked items below).
Common types of commercial prepayment penalties
Understanding the language in your loan documents is the first step. Penalty structures vary, but the most common are:
- Percentage-of-balance penalties: A flat percentage (for example, 1%–3%) of the outstanding principal if you pay off early. This is straightforward but can be expensive on large balances.
- Lockout: A period (often 1–5 years) during which prepayment is prohibited entirely.
- Step-down (or step-pay): A percentage penalty that declines over time (e.g., 3% in year one, 2% in year two, 1% in year three).
- Yield maintenance: A formula that compensates the lender for the difference between the loan’s interest income and current market yields; commonly used on commercial loans, and often costly to calculate and pay.
- Defeasance: Borrower replaces the mortgage collateral with a package of government securities that replicate the loan’s cash flows, allowing the lender to be made whole. Defeasance is administratively complex and expensive, typical for commercial CMBS loans.
These definitions and practical examples are explained in more detail in our FinHelp article on how prepayment penalties are calculated.
How Prepayment Penalties Are Calculated on Commercial Loans
Read the loan documents (and the promissory note) first
Before you do anything else, pull the promissory note, mortgage, and any forbearance or modification agreements. The exact legal remedies and calculations for prepayment are spelled out there. Key things to look for:
- Penalty type and formula (yield maintenance, defeasance, flat fee).
- Lockout periods or step-down schedule.
- Cure or waiver provisions and whether the lender can charge any associated legal or breakage costs.
- Assignment or assumption language — can the loan be assumed by a buyer?
If the language is unclear, consult a mortgage attorney. In my practice I require a legal memo that summarizes any prepayment triggers before recommending refinancing steps.
Practical strategies to avoid triggering penalties
1) Negotiate a waiver or consent from the existing lender
- Approach the lender early, ideally with a competing term sheet from another lender to show you have viable options. Lenders may prefer to negotiate (waiving or reducing penalties) rather than lose the deal to a competitor.
- Offer incentives that reduce the lender’s friction: a fee for the waiver, an agreed-for loan modification, or the promise to refinance with the same lender on new terms.
- Use clear negotiation language. Example starter script I’ve used: “We can close a refinance in 60 days with Lender X. We would prefer to keep our relationship with you if you can provide a written waiver of the prepayment penalty or agree to a reduced yield-maintenance payoff. What would you require?”
See our related FinHelp guide on negotiating exit fees and yield spreads for sample scripts and negotiation anchors.
Negotiating Exit Fees and Yield Spreads in Commercial Loan Refinancing
2) Assumption or transfer to a buyer
- Some commercial loans are assumable. If your sale or recapitalization involves a buyer that can assume the loan, you may avoid a prepayment entirely.
- Assumptions require lender consent in many cases, and the buyer must meet underwriting standards. Check the loan’s substitution/assumption clause and seek lender approval in writing.
3) Loan modification or extension with current lender
- Instead of paying the loan off, negotiate a modification: extend term, change amortization, or reduce rate. This avoids payoff and the penalty while achieving similar economic outcomes.
- Lenders often prefer modifications if the borrower remains creditworthy.
4) Use the same lender for the refinance
- If you need new money or a rate drop, underwriting with the existing lender and rolling the old loan into a new loan with them can eliminate the payoff event or trigger a negotiated modification.
5) Refinance under a permitted prepayment window
- Some loans allow prepayment only in certain windows (e.g., at 25-year anniversary or during defined call periods). Time your refinance to coincide with an allowed window.
6) Structural workarounds: defeasance swaps and escrow-funded payoffs
- For CMBS and some commercial loans with yield maintenance or defeasance, you may be able to fund a defeasance or buy the yield maintenance curve by purchasing securities. This requires specialists; weigh third-party fees against the penalty.
7) Partial prepayment strategies
- Some loans permit partial prepayments without penalty above a certain threshold or at specific intervals. A strategic partial paydown may reduce future penalty amounts or free you to refinance later.
8) Bridge or mezzanine loans to cover a penalty while you restructure
- In some situations, borrowing short-term to cover a prepayment fee can make economic sense if the new financing reduces rate cost enough to recoup the fee quickly. Model the break-even period carefully.
Calculating break-even: when paying the penalty still makes sense
Refinancing with a prepayment penalty can be the right move when the present value of future savings exceeds the buyout cost. Steps:
- Compute the total payoff cost (principal + prepayment penalty + legal/closing costs + defeasance/third-party fees).
- Estimate annual savings from the new loan (interest savings + reduced fees or taxes where applicable).
- Calculate payback period and net present value (discount at a conservative rate, e.g., your expected return on capital or after-tax cost of debt).
- Evaluate alternative uses of cash and the risk of interest rates rising further.
In my experience advising owners, a payback under 24 months usually justifies paying a moderate prepayment penalty; a payback longer than 5 years needs closer underwriting and scenario stress-testing.
Compliance, tax, and accounting considerations
- Tax treatment: Interest vs. penalty treatment can matter for taxes. Some prepayment fees are treated as interest, others as penalties — check with your tax advisor. The IRS rules and case law can treat large yield-maintenance payments as adjustments to interest income for lenders.
- Accounting: Prepayment fees and defeasance costs may be treated differently on balance sheets (deferred costs, impairment), affecting covenants.
- Regulatory issues: For certain small-business programs or SBA-backed loans, additional rules may apply. Always confirm with your lender and counsel.
Checklist: steps to execute a penalty-free refinance
- Pull all loan documents and summarize prepayment language.
- Get a written payoff quote from the lender and ask for the exact formula/calculation.
- Run a break-even NPV model including fees and taxes.
- Solicit at least two competing term sheets (internal or external lenders).
- Present terms to existing lender and negotiate waiver/mod or consent to assumption.
- If defeasance is needed, engage a defeasance consultant and get cost estimates.
- Secure written waiver or amendment before closing new financing.
- Close new financing only after confirming payoff mechanics with both lenders and your attorney.
Negotiation red flags and traps
- Verbal promises: Insist on written waivers. Lenders may change positions before funding.
- Hidden fees: Legal and trustee fees often attach to defeasance and yield-maintenance payoffs.
- Short timelines: Rushing can increase mistakes; require clear timelines in writing.
- Non-compete clauses or cross-default language in other agreements — confirm no surprise triggers.
Real-world examples (anonymized)
-
Retail center refinance: A client faced a 2% flat penalty on $3 million outstanding. Competing term sheets and a $10,000 waiver fee negotiated down the penalty to 0.5%, netting an immediate monthly interest saving that paid back in 18 months.
-
CMBS loan defeasance: For a $12 million CMBS loan with defeasance required, the client evaluated defeasance costs vs. staying on existing terms and chose a targeted sale to transfer the loan via assumption, avoiding the defeasance cost.
These examples reflect typical trade-offs: direct payoff with a fee versus structural or transactional alternatives that avoid a cash buyout.
Where to get help
- Commercial mortgage brokers and advisors can create competitive term sheets and structure defeasance or assumption transactions.
- Mortgage attorneys review documents and draft waiver/amendment language.
- Defeasance specialists and trustees provide exact costs and timing for CMBS payoffs.
For practical negotiation language and exit-fee strategies, see our guide on negotiating exit fees and yield spreads.
Negotiating Exit Fees and Yield Spreads in Commercial Loan Refinancing
For detailed mechanics of penalty calculations, see:
How Prepayment Penalties Are Calculated on Commercial Loans
And for foundational terms like prepayment clauses, read:
Prepayment Clauses: What They Mean for Your Mortgage or Loan
Frequently asked questions
Q: Are commercial loans more likely to have penalties than residential loans?
A: Yes. Commercial lenders commonly include yield-maintenance, defeasance, or flat penalties because loan sizes and interest-rate sensitivity are greater. The Consumer Financial Protection Bureau provides consumer-focused guidance, but commercial loan terms are typically negotiated case-by-case (CFPB).
Q: Can I refinance during a lockout by negotiating a fee?
A: Sometimes. Lenders may accept a negotiated fee or structured workaround (modification or defeasance). Always get written consent.
Final tips (from my practice)
- Start early. Negotiations and defeasance can take weeks or months.
- Build credible alternatives. Lenders move when they can see you have other options.
- Insist on written waivers or amendments — and have your attorney review the payoff mechanics.
- Model the NPV carefully, including tax and accounting impacts; a small-looking fee on a large loan can change the math.
Professional disclaimer: This article is educational only and is not a substitute for legal, tax or financial advice. For action tailored to your loan, consult a commercial mortgage attorney, accountant, or qualified broker.
Author note: In my 15 years advising commercial property owners, I’ve found that negotiating early with a clear competitive alternative and a written waiver is the single most reliable way to avoid expensive, surprise prepayment costs.
Authoritative resources and further reading:
- Consumer Financial Protection Bureau: guidance on prepayment penalties and consumer protections (CFPB.gov)
- Investopedia: definitions of yield maintenance and defeasance
- FinHelp.io glossary pages linked above for calculation and negotiation techniques
