Understanding prepayment penalties on commercial loans

Prepayment penalties are contractual fees lenders use to compensate for interest income they lose when a commercial loan is paid off early. They show up in many commercial mortgage and term-loan agreements, and the structure, duration, and size of the penalty can materially affect whether refinancing or an early payoff makes financial sense.

In my 15 years arranging and negotiating commercial financing for businesses and investors, I’ve seen prepayment language range from strict yield-maintenance clauses that effectively lock borrowers in, to flexible step-downs or no-penalty periods that preserve refinancing optionality. Knowing how these clauses work — and how to negotiate or work around them — can save your business tens of thousands of dollars.

(For general borrower guidance, see the U.S. Small Business Administration and Consumer Financial Protection Bureau resources.)

Types of prepayment penalties and how they affect cost

  • Exit fees: A simple flat fee or a percentage of the outstanding principal (e.g., 1–3%). Easy to calculate but can still be costly for large balances.
  • Yield maintenance: Designed to make the lender “whole” by compensating the difference between the loan’s interest rate and current market rates for the remaining term; often the most expensive and complex to compute.
  • Declining or step-down penalties: The charge falls each year until it disappears, giving borrowers flexibility as the loan ages.
  • Defeasance (common in CMBS loans): The borrower substitutes substitute securities to match remaining cash flows — complex and often expensive.

Each structure creates a different refinancing break-even point. For example, a 3% exit fee on a $1 million balance is $30,000; yield maintenance could be larger depending on interest-rate spreads and remaining term.

Strategic approach: plan before you borrow

  1. Start with the loan term sheet, not the promissory note. The term sheet is where you negotiate economics and prepayment language. Ask for the exact clause wording and a sample payoff calculation.
  2. Bring your team. Have your attorney and broker review prepayment clauses during term negotiation. Lawyers who specialize in commercial lending recognize standard traps and can propose borrower-friendly language.
  3. Seek a no-penalty period. Many lenders will agree to a no-prepayment or “soft call” window (commonly 6–24 months). This protects early refinancing for short-term strategies.
  4. Negotiate a step-down. If a lender insists on a penalty, a declining schedule (e.g., 3% year 1, 2% year 2, 1% year 3, 0% year 4+) preserves long-term flexibility.

Tactics to reduce or avoid penalties after closing

  • Refinance with the same lender: Some banks will refinance into a new product without applying the penalty if you meet underwriting criteria. This can be faster and cheaper than moving to a new lender.
  • Request waiver on business grounds: If you’ve demonstrated strong performance (timely payments, improved DSCR), lenders may agree to lower or waive the charge when you propose refinancing.
  • Negotiate cashless swaps: Offer a yield spread premium or slightly higher rate on the new loan in exchange for the lender waiving prepayment fees.
  • Partial prepayment: If the loan allows, prepay a portion so the remaining balance is easier to manage; some agreements cap penalties or exclude partial prepayments under certain thresholds.

Use alternative finance structures where appropriate

  • Lines of credit and revolvers: For working-capital needs and short-term flexibility, lines of credit typically don’t carry prepayment penalties the way long-term term loans do.
  • SBA loans: SBA 7(a) and CDC/504 programs often have borrower-friendly prepayment terms relative to commercial bank mortgages (see SBA resources at sba.gov). Review specific SBA product rules; some SBA loans have limited or graduated prepayment charges.
  • Bridge loans with clear exit strategies: If you plan to refinance quickly, structure a short-term bridge with terms that explicitly allow early payoff without harsh penalties.

When refinancing, run a clean break-even calculation

Always compare the cost of the new loan plus any prepayment charge against the savings from the lower rate or better terms. Include:

  • Prepayment fee (exit fee, yield-maintenance estimate, defeasance costs)
  • Closing costs on the new loan (appraisal, legal, origination fees)
  • Any tax or accounting effects
  • Time horizon: how long you plan to keep the new loan

A simple discounted cash-flow calculation or break-even analysis usually tells the story: refinancing is worthwhile only if the net present value of future savings exceeds the combined transaction and penalty costs.

Negotiation language that helps borrowers

Ask your attorney to propose or negotiate these borrower-friendly clauses:

  • A limited no-penalty period (e.g., first 12–24 months)
  • A step-down schedule tied to anniversary dates
  • Carve-outs for sale or casualty (no penalty if the property is sold because of an involuntary event)
  • A cap on the maximum penalty amount (e.g., not more than X% of the outstanding balance)
  • “Lender consent” language that requires lender to act reasonably when considering a waiver

Case examples from practice

  • Office property investor: We negotiated a 3-year soft call and declining penalty thereafter, allowing the investor to refinance after stabilizing rents without a $30,000 exit fee they were originally quoted.
  • Restaurant owner: Rather than accept a 2% exit fee, we moved to an alternative lender providing a similar rate with no prepayment charge; the owner saved both on interest and avoided the fee when rates fell.

When penalties are unavoidable: minimize their impact

  1. Use partial prepayments and recasts if permitted. Some loans allow re-amortization after a partial principal reduction, lowering payments without triggering a full prepayment event.
  2. Accelerate prepayments into principal-only windows. Make extra principal payments during times the loan permits free prepayments.
  3. Time your refinance intelligently. If you’re within a window when step-downs reduce the penalty, wait if market conditions allow.

Legal and compliance checklist before signing

  • Obtain a written payoff example from the lender for several early-payoff dates and request the exact calculation method.
  • Ask whether defeasance is required (common in CMBS) and get an estimated cost.
  • Confirm whether partial prepayments or sale-related prepayments are exempt.
  • Have counsel confirm that any negotiated changes are reflected verbatim in the loan documents, not just the term sheet.

Useful internal resources and further reading

Common pitfalls to avoid

  • Accepting boilerplate penalty language without reviewing real payoff examples.
  • Assuming a lower rate always offsets prepayment charges — calculate the true break-even.
  • Forgetting to get negotiated concessions written into final loan docs.

Quick negotiation checklist (one-page action plan)

  • Request term sheet and sample payoff calculations
  • Bring attorney and broker into initial negotiations
  • Seek a no-penalty period or step-down schedule
  • Compare lenders and alternative products (SBA, lines of credit)
  • Model refinance scenarios with all fees included
  • Confirm final language in loan documents before signing

Professional note and disclaimer

In my commercial lending practice, borrowers saved substantial amounts by focusing negotiations on prepayment language early in the deal and by running disciplined refinance break-even analyses. This article is educational and does not substitute for individualized legal, tax, or financial advice. Consult your attorney and financial advisor before signing or amending loan documents. For general borrower resources, see the U.S. Small Business Administration (sba.gov) and the Consumer Financial Protection Bureau (consumerfinance.gov).