A prepayment penalty is a fee a lender charges when a borrower pays off some or all of a loan balance ahead of the scheduled term. Lenders build in this fee to protect the return they expected to earn in interest over the life of the loan, since an early payoff cuts that interest income short.
Commercial real estate loans structure prepayment penalties in several common ways, including a flat percentage of the outstanding balance, a step-down schedule that decreases the penalty each year, or yield maintenance, which calculates a fee designed to make the lender economically whole based on prevailing interest rates. Some loans include a lockout period during which prepayment is not permitted at all. For sponsors and investors, prepayment penalties matter most when a property might be refinanced or sold before the loan's natural maturity, since an unexpectedly large penalty can erode returns. Reviewing this provision closely during underwriting helps avoid surprises if the business plan calls for an earlier-than-planned exit.
Further reading: The Lightstone DIRECT Story
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