Overview

Prepayment penalties are contractual charges lenders use to recover interest or other costs they expected to earn if a commercial loan ran to maturity. They are common on fixed-rate commercial mortgages and term loans but vary widely by lender, loan product, and market conditions. Unlike many consumer mortgage protections, commercial loan terms are negotiated between sophisticated parties and are generally enforceable as written (see Consumer Financial Protection Bureau for consumer protections only: https://www.consumerfinance.gov).

In my practice advising small and mid-size commercial borrowers, I repeatedly see that the penalty structure can swing a refinancing decision. A borrower who thought refinancing would save money often discovers the prepayment fee erodes or eliminates the savings unless the calculation method is understood and negotiated in advance.

Common types of prepayment penalties

Commercial loan agreements typically use one or more of these approaches:

  • Percentage of outstanding principal: A flat percentage (e.g., 1%–3%) applied to the principal balance at payoff. Simple and transparent.
  • Flat fee: A fixed dollar amount specified in the loan documents.
  • Sliding scale (step-down): A percentage that decreases each year or month (e.g., 3% in year 1, 2% in year 2, 1% in year 3).
  • Yield maintenance: The borrower pays the present value of the lender’s lost interest income, using a market rate (Treasury or swap curve) to discount future payments. More precise for the lender’s economics.
  • Defeasance: Common in commercial mortgage-backed securities (CMBS) loans. The borrower substitutes U.S. Treasuries or other approved securities to produce the same cash flows the lender expected.
  • Breakage cost / bank loss: For loans tied to the bank’s funding cost or hedges (e.g., swaps), the prepayment amount covers the actual cost to unwind those positions.

Each method produces different outcomes: percentage methods are predictable but can over- or under-compensate the lender; yield maintenance and defeasance track market rates closely and are typically more expensive for borrowers when market rates are low relative to the loan rate.

How to calculate each type (formulas and examples)

Below are step-by-step examples you can follow using figures from your own loan documents.

1) Percentage of outstanding principal
Formula: Penalty = Outstanding Principal × Penalty Rate
Example: Outstanding principal = $1,000,000; penalty rate = 2% → Penalty = $1,000,000 × 0.02 = $20,000.

2) Flat fee
Formula: Penalty = Specified flat amount in loan agreement
Example: Flat fee = $10,000 regardless of remaining balance.

3) Sliding scale
Formula: Penalty = Outstanding Principal × Applicable Yearly Rate
Example: Year 2 penalty = 1.5% on $800,000 outstanding → $12,000.

4) Yield maintenance (common on commercial mortgages)
Concept: Compute the present value (PV) of the remaining scheduled loan payments (interest and principal) using a market discount rate, then subtract the outstanding principal. The difference is the lender’s lost interest income, which the borrower must cover.
Basic steps:

  • List the remaining scheduled payments (interest and principal) through maturity.
  • Choose the discount curve specified in your loan (often Treasury yields or a swap curve with a stated spread).
  • Discount each remaining payment to present value using that curve and sum the PVs.
  • Subtract outstanding principal. The result is the yield‑maintenance amount.
    Example (simplified):
  • Remaining scheduled interest and principal = $200,000 total to be paid over future periods.
  • Discounted PV at the specified Treasury rate = $180,000.
  • Outstanding principal = $150,000.
  • Yield maintenance penalty = $180,000 − $150,000 = $30,000.
    Note: In real calculations you must discount each cash flow separately; loan documents often specify the exact Treasury maturities and spread to use. If the loan is CMBS, defeasance may be required instead.

5) Defeasance
Concept: The borrower buys a portfolio of U.S. Treasuries or agency securities that replicate the loan’s remaining cash flows. The lender releases the property and loan, and the securities pay the investor. This can be costly due to transaction fees and the price of securities that match the schedule.

6) Breakage cost / swap unwind
Concept: If the lender hedged the loan (e.g., with an interest-rate swap) the prepayment fee covers the cost to unwind the hedge. The loan documents should state how the bank calculates that cost.

Step-by-step checklist to compute your specific penalty

  1. Pull the exact loan docs: promissory note, loan agreement, mortgage deed, and any riders. The formula and discount curve are almost always in writing.
  2. Identify the penalty type (percentage, flat, yield maintenance, defeasance, other).
  3. Get current outstanding principal and the loan payoff date.
  4. If yield maintenance is used, obtain the discount rates specified (Treasury curve dates, yields, spreads) and the remaining payment schedule.
  5. Run the calculation or ask the lender for a certified payoff statement that itemizes the prepayment charge and the method.
  6. Compare the prepayment penalty to the expected savings from refinancing (total interest savings minus fees and penalties). For help timing and documents, see our refinancing timeline guide.

Resources on our site: see our refinancing timeline article and our refresher on when to consider refinancing for guidance: Building a Refinance Timeline: Documents, Rates, and Closing Steps and Refinancing 101: When to Refinance Your Loan.

Practical examples

Example A — Percentage method:

  • Outstanding principal = $500,000
  • Penalty = 3% of outstanding principal
  • Penalty = $15,000
    This is straightforward and often used on smaller commercial term loans.

Example B — Yield maintenance (simplified):

  • Loan has 5 years left with scheduled interest and principal = $250,000
  • Discount PV at specified Treasury rate = $230,000
  • Outstanding principal = $200,000
  • Yield maintenance penalty = $230,000 − $200,000 = $30,000
    This can be more expensive than a flat percentage, especially when market rates fall below the loan rate.

Negotiation and strategies to reduce or avoid penalties

  • Negotiate at origination: Ask for no prepayment fee, a short penalty window (e.g., first 1–2 years only), or a soft prepayment (allows payoffs from property sale without penalty).
  • Seek a step-down schedule so penalties reduce quickly.
  • Request a buyout cap: a maximum dollar cap on any prepayment charge.
  • Offer a partial prepayment clause if you only need to reduce principal and not extinguish the loan.
  • Consider assigning the loan or assumption rights if allowed—this can avoid a payoff that triggers a penalty.
  • When refinancing, run a full break-even analysis: include closing costs, prepayment penalty, appraisal, and legal fees.

In negotiations I’ve seen lenders accept a reduced penalty if the borrower agrees to a replacement loan with the same lender or provides a fee that compensates the bank’s real costs rather than theoretical lost yield.

Tax and legal considerations

  • Tax treatment: For businesses, many courts and tax advisers treat prepayment penalties as interest or interest-related and allow deduction as an ordinary business expense. Rules vary and IRS guidance changes—consult your CPA and review IRS Publication 535 (Business Expenses) for current practice (https://www.irs.gov/publications/p535).
  • Legal enforceability: Commercial loan agreements are typically governed by contract law in the chosen state. Penalties that are unconscionable or that violate specific statutes could be challenged, but challenges are rare in commercial settings. Work with legal counsel when reviewing or disputing fees.
  • Regulatory: Consumer protections (CFPB) focus on consumer mortgages; commercial loans don’t generally enjoy the same statutory caps (https://www.consumerfinance.gov).

Common pitfalls borrowers make

  • Failing to read the loan documents thoroughly; relying on verbal promises.
  • Only comparing headline interest rates without including prepayment cost in an apples-to-apples refinance analysis.
  • Assuming a lender will reduce or waive prepayment penalties without a concrete alternative proposal.
  • Overlooking defeasance requirements on CMBS loans, which can add significant transaction and securities costs.

Final checklist before you repay or refinance

  • Obtain a written payoff statement showing how the prepayment charge is calculated.
  • Run a net benefit analysis: expected interest savings − (prepayment penalty + closing costs) = net benefit.
  • Get legal review if language is ambiguous or if the penalty seems disproportionate.
  • Confirm tax treatment with your CPA.

Authoritative sources and further reading

Professional disclaimer

This article is educational and not personalized legal, tax, or investment advice. Terms in commercial loan agreements are negotiable and fact-specific; consult your attorney, tax adviser, and lender for decisions about a particular loan.

If you want, I can walk through a sample payoff calculation using numbers from your loan documents or review language in a prepayment clause and explain what to watch for.