Prepayment Penalty in Commercial Mortgages
A prepayment penalty is the cost a borrower owes for repaying a commercial mortgage before scheduled maturity. A common form is a declining percentage of the loan, such as a 5-4-3-2-1 schedule that starts at 5 percent in year one and steps down 1 point each year. Conduit CMBS prepayment is tightly constrained, while transitional floating-rate bridge loans can often be repaid early without a penalty. The cost belongs in every sale, refinancing or recapitalization comparison.
How a stepped percentage schedule prices an early exit
The simplest penalty is a percentage of the mortgage that falls as the loan seasons. A 5-4-3-2-1 schedule charges 5 percent in year one, 4 percent in year two, and continues down by 1 point a year.
The step-down matters because the same payoff costs a different amount depending on the date. A borrower planning a sale or refinancing inside the early years is pricing the loan at its most expensive point, and a delay of twelve months can lower the percentage by a full point.
The total payoff is built in layers: unpaid principal, accrued interest, and the penalty. Keeping the penalty on its own line lets a reader see what the early exit costs beyond the debt itself.
Why conduit and bridge loans carry different exit costs
Prepayment terms follow loan structure. Conduit CMBS prepayment is tightly constrained, while transitional floating-rate bridge loans can be prepaid early without a penalty. Agency floating-rate loans in the K-Deal program also offer borrowers more prepayment flexibility.
Conduit pools hold a large number of individual fixed-rate loans, perhaps 150 to 300. Large-loan deals hold only a few floating-rate mortgages, perhaps 5 to 20. A borrower in either pool is a small piece of a securitized cash flow stream, which is why a fixed-rate conduit loan and a floating-rate bridge loan sit at opposite ends of the exit-cost range.
A floating-rate alone does not guarantee penalty-free payoff. The flexibility belongs to transitional bridge structures, and the signed loan terms decide the cost for any specific loan.
How the shift toward floating-rate and shorter debt changes exposure
Issuance has moved toward five-year loans and floating-rate single-asset, single-borrower debt, which has reduced conduit volume. In one annual snapshot of private-label CMBS loans scheduled to mature, about 78 percent were floating-rate.
A borrower holding shorter floating-rate debt generally faces a different early-exit question than one holding a ten-year fixed-rate conduit loan. The fixed-rate holder checks the penalty schedule against the planned exit date. The floating-rate holder checks the full set of payoff terms in that loan’s documents.
Worked example: payoff of an $18 million loan in year two versus year four
The figures are hypothetical. A borrower holds a fixed-rate loan with an unpaid balance of $18,000,000 under a 5-4-3-2-1 schedule. A new lender offers a refinancing that cuts the interest rate by 0.50 percent. Refinancing costs are $90,000 in both cases. To compare on the same basis, the balance is held at $18,000,000 in both cases and amortization is ignored.
Base case, payoff in year two at 4 percent: $18,000,000 multiplied by 0.04 is $720,000. Adding $90,000 of refinancing costs gives $810,000 of exit cost.
Alternative case, payoff in year four at 2 percent: $18,000,000 multiplied by 0.02 is $360,000. Adding $90,000 gives $450,000. Waiting two years lowers the penalty by $360,000.
The annual interest saving is $18,000,000 multiplied by 0.005, or $90,000 a year. The year two payoff recovers its $810,000 cost in $810,000 divided by $90,000, or 9 years. The year four payoff recovers its $450,000 in $450,000 divided by $90,000, or 5 years.
This payback test shows why timing and schedule position decide the economics. It ignores amortization, the cost of holding the old loan during the wait, and any change in rates, so it frames the comparison and does not settle it.
Mistakes in analyzing prepayment penalties
Treating the schedule label as the whole payoff formula leaves out principal, accrued interest and other charges. A 4 percent step applied to the mortgage is one line of the payoff statement, so the total owed is larger than the penalty alone.
Applying the percentage to the wrong balance changes the answer. A percentage of current unpaid principal is smaller than the same percentage of original principal once amortization has reduced the loan, and the choice moves the figure by the amount of principal repaid.
Comparing only the penalty with the interest saving ignores refinancing costs. In the example, the penalty alone is $720,000 in year two, while the full exit cost is $810,000, which stretches payback from 8 years to 9.
Assuming every floating-rate loan prepays freely extends a feature of transitional bridge loans to all floating-rate debt. Loan structure and the executed terms control, and a floating-rate is only a starting hypothesis.
Prepayment penalty checklist questions
Which loan structure applies? Conduit CMBS, agency floating-rate and transitional bridge loans sit at different points on the flexibility range.
What schedule governs the loan? A 5-4-3-2-1 step-down and a flat percentage produce very different costs at the same date.
On what date does each step begin and end? The payoff date fixes the percentage, so a few weeks can move the cost by a full point.
Which balance does the percentage apply to? Original principal and unpaid principal give different dollar figures once amortization has occurred.
What other amounts sit in the payoff statement? Accrued interest and charges belong beside the penalty, not folded into it.
What are the refinancing costs on the replacement loan? Those costs lengthen the payback period on the penalty.
How long is the expected hold after the refinancing? A payback period longer than the planned hold means the interest saving does not cover the exit cost.
Is each scenario priced on the same payoff date and balance? A like-for-like basis keeps a comparison of penalties meaningful.