Prepayment Penalty

A prepayment penalty is a fee charged when a borrower pays off a loan, or a large part of it, earlier than the schedule allows. Lenders price a loan expecting to earn interest for a set time. If the borrower refinances after rates fall, that income disappears. The penalty, sometimes called a prepayment premium, makes up for some of the loss.

Commercial loans use three common structures:

• Step-down. A percentage of the balance that falls each year. A "3-2-1" schedule charges 3% in year one, 2% in year two, 1% in year three and nothing after. On a hypothetical $2,000,000 balance paid off in year two, the fee is $40,000.
• Yield maintenance. A formula that charges roughly the present value of the interest the lender loses, based on the gap between the loan rate and a comparable Treasury yield. The lower rates fall, the higher the fee.
• Defeasance. Instead of paying off, the borrower buys government securities that produce the same payments as the loan, and those securities replace the property as collateral. This is common on loans packed into commercial mortgage-backed securities.

The promissory note or loan agreement sets out which structure applies, any "open" window near maturity with no penalty, and whether partial prepayments count.

Why it matters for lenders

The penalty protects the yield the lender planned on and helps it match loan terms to its own funding. A steep penalty keeps a loan on the books; a light one invites early refinancing.

Some government programs set their own rules. As of 2026, the Small Business Administration (SBA) charges a subsidy recoupment fee on 7(a) loans with maturities of 15 years or more when the borrower voluntarily prepays 25% or more of the balance during the first three years. Lenders making SBA 7(a) loans need to know whether a payoff triggers it. State law can also limit prepayment charges on some loans, so lenders should check with counsel.

How it works in practice

A borrower calls a private lender to pay off a five-year term loan in month 20 because they are selling the building. The servicing specialist opens the loan record, confirms the step-down schedule and calculates the fee for the payoff date.

The fee goes on the payoff statement next to the principal, accrued interest and any other charges, with a good-through date and a daily interest figure. A second person checks the numbers before the statement is sent.

Errors happen when the penalty terms live only in the PDF of the note. Staff may miss a fee the lender is owed, or charge one the documents do not allow. Recording the structure on the loan at boarding lets the system calculate it the same way every time.