A prepayment penalty is a fee charged by a lender if a borrower pays off a loan before its due date. For commercial mortgages, there are several types of prepayment penalty structures:
Yield Maintenance: Yield maintenance is a prepayment penalty structure that is designed to protect the lender's expected yield on the loan. If the borrower pays off the loan early, the lender will calculate the present value of the remaining loan payments and charge the borrower the difference between the present value and the loan's original principal. This penalty structure can be expensive, as it requires the borrower to pay the lender the full amount of the expected yield on the loan.
Defeasance: Defeasance is a prepayment penalty structure that involves replacing the original collateral with other assets that generate cash flows similar to the original collateral. This structure is typically used in commercial mortgage-backed securities (CMBS) loans. The borrower must purchase and hold the replacement collateral until the loan's original maturity date.
Step-Down: Step-down prepayment penalties decrease over time. For example, a loan might have a prepayment penalty of 5% in the first year, 4% in the second year, 3% in the third year, and so on until the penalty reaches 0%. This structure can be beneficial for borrowers who plan to pay off their loan in the later years of the loan term.
Soft: A soft prepayment penalty is a structure where the lender only charges a penalty if the borrower refinances the loan with another lender. If the borrower pays off the loan from their own funds, there is no penalty. This structure is less common in commercial mortgages than in residential mortgages.
The primary differences between these prepayment penalty structures are the costs and the flexibility they offer borrowers. Yield maintenance and defeasance are typically the most expensive structures for borrowers, while step-down and soft penalties can be less costly. Borrowers should consider the prepayment penalty structure when choosing a commercial mortgage to ensure that it aligns with their financial goals and plans.
If you have any questions about this article or would like to discuss a scenario of your own with our team, please feel free to contact Colin Dubel at colin@harborwestcommercial.com or 949-735-6415.
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