Prepayment penalty

How a prepayment penalty works

The CFPB describes a prepayment penalty as a fee some lenders charge if a borrower pays off all or part of a mortgage early. Federal consumer rules limit prepayment penalties on many consumer mortgages, but business-purpose credit is generally outside those rules (12 CFR 1026.3(a)), so on investor loans the terms come from the note, subject to state law.

Common structures on private and investor loans:

• Step-down: a percentage of the balance prepaid that falls each year, written as a list of yearly percentages (a hypothetical 3-2-1 means 3% in year one, 2% in year two, 1% in year three).
• Minimum interest: the borrower owes a set number of months of interest even if it repays sooner, common on short bridge loans.
• Yield maintenance or defeasance: on larger commercial loans, a payment that compensates the lender for lost interest.

Why it matters to a private lender

Bridge and fix-and-flip loans are meant to repay early, so long penalties rarely fit them; a minimum interest period is more common. On DSCR rental loans, a prepayment penalty protects the yield that a loan buyer or capital partner pays for, and buyers often price loans with longer prepayment protection more favorably. Make sure the penalty is clearly written, allowed in the property’s state, and shown on your loan tape.

Example

Hypothetical. A $300,000 DSCR loan has a 3-2-1 step-down. If the borrower refinances in year two, it pays 2%, or $6,000.

See how loan buyers price bridge and DSCR loans.