Prepayment penalty

A prepayment penalty is a fee for repaying a loan early. It compensates the lender for interest it expected to earn and will not now receive.

Where they still appear#

Consumer mortgage rules have made them rare on owner-occupied residential loans, where they are tightly restricted in size and duration and cannot appear at all in some loan categories.

They remain entirely normal in:

• commercial mortgages
• hard money and bridge lending
• investment-property and DSCR loans
• some seller-financed notes

An investor who assumes the consumer rules apply to a rental-property loan is assuming something that is usually false.

The common structures#

A step-down penalty shrinks annually — often five percent of the balance in year one, four in year two, down to nothing. It is the most common form in investment lending and it makes the timing decision arithmetic rather than guesswork.

A flat penalty charges the same percentage throughout the penalty period.

A yield maintenance or defeasance provision, used in larger commercial loans, requires the borrower to make the lender whole for the interest lost, which can be far more expensive than a percentage penalty and is considerably harder to estimate in advance.

The threshold detail people miss#

Many notes permit prepayment up to a stated share of the balance each year — twenty percent is a common figure — without penalty, and charge only on amounts beyond it.

That means voluntary extra payments are usually fine and a full payoff is not. Which is exactly backwards from what most borrowers assume when they see the phrase.

Why it matters at exactly the wrong moment#

The penalty applies when the loan is repaid, which is when a property is sold or refinanced. Both of those are decisions made under time pressure, and both happen at the moment a household or an investor is least able to absorb an unexpected several thousand dollars.

For anyone flipping a property on hard money, the penalty is a real input to the deal and belongs in the numbers alongside points and interest — not discovered on the payoff statement three days before closing.

Finding out#

Ask for a payoff statement before committing to anything. It will show the penalty as a line item, and it will show the date through which the quoted figure is good. Both matter.

What to negotiate#

On lending where penalties are normal, the penalty is a term like any other and it can be argued about.

Three things are worth asking for. A shorter penalty period — two years rather than five changes the exit options substantially. A sale exemption, so that a genuine arm's-length sale does not trigger it even if a refinance would. And a larger annual prepayment allowance, which lets principal be paid down voluntarily without charge.

Lenders price these. A shorter penalty usually costs something in rate. But the trade is at least visible, which is more than can be said for discovering the term on a payoff statement.