How Do Commercial Loan Prepayment Penalties Work?
Commercial loan prepayment penalties protect lenders from lost interest income when borrowers pay off loans early. The three main types are yield maintenance (compensates the lender for the full rate differential — most expensive when rates decline), defeasance (borrower purchases Treasury securities to replace the loan's cash flows — complex and costly), and step-down (a declining percentage of the balance — simplest and most predictable). In a declining-rate environment, yield maintenance and defeasance can cost $200,000-$400,000+ on a $2-5M loan, making refinancing uneconomic even when rates drop significantly.
Key Facts
Yield Maintenance: The Most Common — and Most Expensive
Yield maintenance requires the borrower to compensate the lender for all the interest income they would have earned over the remaining loan term. The calculation uses the difference between your note rate and the current Treasury yield multiplied by the outstanding balance for the remaining months. When rates decline, the spread widens and the penalty increases — meaning the exact market conditions that create the biggest refinancing opportunity also create the biggest exit cost. On a $2.5M loan at 8.00% with 5 years remaining and a 4.00% Treasury, yield maintenance could exceed $250,000.
Defeasance: Treasury Substitution
Common in CMBS loans, defeasance does not pay off the loan. Instead, the borrower purchases a portfolio of U.S. Treasury securities whose cash flows match the remaining loan payments. The Treasuries replace the real estate as collateral, and the borrower's lien is released. The cost includes the Treasury portfolio itself (which rises when rates fall, since bond prices move inversely to yields), plus $25,000-$50,000 in legal and transaction fees. Defeasance is technically more complex than yield maintenance but produces similar total costs in most rate environments.
Step-Down Penalties: Simple and Predictable
Step-down penalties decline on a fixed schedule regardless of market conditions. A typical structure is 5-4-3-2-1: a 5% penalty in year one, declining by one percentage point per year until it reaches zero in year six. On a $2M balance in year three, the penalty is 3%, or $60,000. Step-downs are less punitive than yield maintenance in sharply declining-rate environments, making them the most borrower-friendly prepayment structure among penalty-bearing loan types. Many portfolio lenders default to step-down structures.
How to Avoid Prepayment Penalties
Portfolio bank loans are the most common source of no-penalty commercial financing — community banks and credit unions often offer penalty-free options for a 25-50 basis point rate premium. Bridge loans are almost universally penalty-free. DSCR-based investor programs frequently offer no-penalty options on shorter fixed-rate terms. The key question is whether the rate premium for flexibility is worth it given your hold period, rate outlook, and exit strategy. In a declining-rate environment, borrowers who paid the premium for a penalty-free structure routinely save $100,000-$300,000+ compared to borrowers locked into yield maintenance.
Prepayment Penalty Types — Comparison
Cost, complexity, and when each applies
| Yield Maintenance | Defeasance | Step-Down | |
|---|---|---|---|
| How It Works | Pay rate differential | Buy matching Treasuries | Declining % of balance |
| Cost When Rates Fall | Very high | Very high | Fixed schedule |
| Cost When Rates Rise | Low/zero | Low/zero | Fixed schedule |
| Transaction Fees | Minimal | $25K–$50K+ | Minimal |
| Complexity | Moderate | High (legal/servicer) | Simple |
| Common In | Banks, Life Cos | CMBS | Portfolio lenders |
| Example ($3M, Yr 3) | $150K–$300K+ | $150K–$300K+ | $90K (3%) |
Licensed in Oregon & California · NMLS #1498678
From the Blog
Further Reading
CommercialNo Prepayment Penalty: Why Smart Commercial Borrowers Are Positioning for a Declining-Rate Environment
Yield maintenance, defeasance, and step-down penalties can cost hundreds of thousands of dollars when you refinance a commercial loan early. In a declining-rate environment, borrowers locked into penalty-heavy structures are watching cheaper capital pass them by. Here’s how no-prepayment-penalty commercial loans let you capture every basis point of savings when rates fall.
CommercialLife Company Loans for Commercial Refinance: The Gold Standard That Isn't Right for Everyone
Life company loans offer the lowest fixed rates in commercial real estate — often beating banks, CMBS, and credit unions by 20-50 basis points. But ultra-conservative leverage, strict prepayment penalties, and highly selective underwriting mean they're a perfect fit for some deals and completely wrong for others. Here's how to know whether a life co refinance belongs in your capital stack.
CommercialCommercial Cash-Out Refinance: How Savvy Investors Tap Equity to Renovate, Rehab, and Expand Their Portfolios
Your commercial property has probably appreciated more than you think — and a cash-out refinance lets you put that equity to work without selling the asset. Here's how smart investors use low-cost, already-owned equity to fund renovations, rehab value-add properties, and grow their CRE portfolios in 2026.