The most common structures for paying off a commercial loan before maturity
Lenders put out money, to make more money in return. Banks in particular like to be able to forecast the money they make on their money, so a nice, juicy, long term loan is a favorite way to do it.
Paying back the bank’s loan early can mess up that comfortable equation. They’d rather you keep the money and pay the interest than have to find another loan to put out. It make them feel less in control, and makes their financial forecasts less certain.
To deal with this, most commercial mortgage lenders utilize a Prepayment Penalty. If you pay the lender back before the pre-determined time (usually close or right at the loan maturity), you won’t be able to simply write them a check for the outstanding loan principal. Instead, you’ll be charged extra.
Here we’ll cover the most common prepayment penalty structures for commercial real estate loans.
When you prepay, the lender calculates the net present value of the interest they would have received of you held the loan to maturity, maintaining their yield/profit from the loan.
Also known as “Step-down”, the lender agrees to a simple schedule of prepayment penalties, often stated year by year. So for a 5 year loan, the schedule might be 5,4,3,2,1, with a few months at the end of the loan where there is no penalty.
It’s impossible to prepay. This would more commonly be a period of the loan, usually early on, rather than the whole term.
Defeasance is used to prepay a CMBS loan (where the loan is cut up into bonds and sold on the open market), but explaining this one would be a longer subject. Suffice it to say, prepaying a CMBS loan through defeasance isn’t cheap or easy, so it’s rarely done.
There are lenders out there with good rates and no prepay penalties as well. This is common for a floating rate loan, but less common for fixed rate notes.
The prepayment penalty for a given commercial loan is typically negotiated at the front end when a lender provides a Term Sheet. If prepayment flexibility is important for your investment plan, it’s always best to ask your loan officer what options they have available. Just because the initial term sheet given to you states that the prepayment penalty will be subject to yield maintenance, doesn’t mean it can’t be changed to, say, step-down. Lenders are paid for risk and prepayment is a risk, so they may soften the prepayment penalty in exchange for a modest bump in the interest rate.