Risk and Failure ModesNil Masferrer JiménezSeptember 24, 2026

Prepayment Penalties: Yield Maintenance, Defeasance and Step-Downs

The rate cap is the risk of floating debt. The prepayment premium is the risk of fixed debt. It rarely appears in the deck, and it can decide whether the business plan's exit year is affordable at all.

Syndications that bought with floating-rate bridge debt learned what rising rates cost. Syndications on fixed-rate debt carry the opposite exposure, and it is harder to see. Fixed-rate loans from agency lenders, life companies and CMBS conduits usually charge a premium for repaying before a date set in the loan documents. The size of that premium moves with interest rates, and it can be a meaningful share of the equity.

This article describes the three common structures, what drives their cost, and where the numbers sit in an offering package.

Why the charge exists¶

A fixed-rate loan is sold on the promise of a fixed stream of payments. The lender, or the investors in the security the loan was pooled into, priced that stream. If the borrower repays early when rates have fallen, the money has to be reinvested at a lower yield. The prepayment premium closes that gap, and each structure closes it differently.

Yield maintenance¶

The borrower pays a premium meant to leave the lender whole. It is calculated as roughly the present value of the difference between the loan's rate and a benchmark Treasury yield over the remaining yield maintenance period. The exact formula, including the benchmark, the discount rate and whether the calculation uses scheduled or remaining payments, is set out in the loan documents.

There is usually a floor. The Fannie Mae Multifamily Guide says the loan documents generally require the greater of 1% of the unpaid principal balance or yield maintenance, for prepayments before the yield maintenance period ends. After that date, a smaller premium or an open window applies, as the documents specify.

The effect is that the premium is large when Treasury yields are well below the loan rate and falls to the floor when they are at or above it.

Defeasance¶

The loan is not repaid at all. The borrower buys a portfolio of government securities that produces cash matching the loan's remaining scheduled payments, and pledges that portfolio in place of the property. The property is released and can be sold, and the loan continues to be paid by the securities until maturity.

Defeasance is common in CMBS loans because of the tax rules for the REMIC trusts that hold them. The Treasury regulation on REMIC qualified mortgages allows a lien to be released if the substitute collateral consists solely of government securities, the release is to facilitate a disposition or other customary commercial transaction, and it is not within two years of the REMIC's startup day. That is why many CMBS loans lock out prepayment entirely in the first years and permit defeasance after.

The economics resemble yield maintenance. When Treasury yields are below the loan rate, the securities portfolio costs more than the loan balance. There are also transaction costs: a defeasance consultant, legal fees, a successor borrower entity, and accountants. When yields are well above the loan rate, the portfolio can cost less than the balance.

Step-down premiums¶

The simplest structure. The premium is a fixed percentage of the balance that falls by schedule, for example from a higher percentage in the first year down to a lower one in later years, and then to an open period. The Fannie Mae guide covers fixed-rate loans with graduated prepayment premiums of this kind. Because the premium does not depend on interest rates, it is predictable. That predictability is why floating-rate and shorter-term loans often use it.

The arithmetic¶

Hypothetical example

The same loan, two rate environments

Hypothetical and simplified. A $20,000,000 fixed-rate loan at 5.0%, interest-only, with five years of yield maintenance remaining at the planned sale date. The calculation ignores amortization and discounting conventions that real loan documents specify.

Treasury yields at 3.5%. The rate gap is 1.5%, or $300,000 of interest a year. Discounted at 3.5% over five years, the present value factor is about 4.515, so the premium is about $1,354,500. The 1% floor would be $200,000, so yield maintenance applies.

Treasury yields at 5.5%. The gap is negative, so the yield maintenance amount is zero and the floor applies: $200,000.

If the partnership has $10,000,000 of limited partner equity, the difference between the two outcomes is about 11.5% of the equity. It comes from nothing the sponsor did at the property, and it arrives in the year of the sale.

Illustrative arithmetic on invented figures. Not a projection, not an offering, and not a representation about any real transaction.

That is the risk in one sentence. A business plan that sells in year five of a ten-year loan is betting, among other things, on where Treasury yields will be in year five.

How it interacts with the rest of the plan¶

Selling into low rates is expensive, and selling into high rates has its own cost. Low yields usually support higher property values and raise the prepayment premium. High yields cut the premium and usually depress the price. The premium softens the benefit of a good rate environment without cushioning a bad one.

A refinance pays the premium too. A plan to refinance and return capital before maturity has to pay its way out of the existing loan first. That is part of the refinance risk that the pro forma may not show.

Assumption is sometimes the alternative. Some fixed-rate loans can be assumed by a buyer, with the lender's approval and a fee set in the loan documents. An assumable loan at a rate below the market can support the sale price instead of penalizing it. Whether the loan is assumable, and on what conditions, is a fact the term sheet states.

Stress shows up here first. The Federal Reserve's Financial Stability Report has tracked commercial real estate valuations and refinancing pressure since rates rose. A deal that has to sell early because of trouble can't choose the rate environment it sells into. It pays whatever the premium is on that date, and that is part of how syndications fail.

Where to find it in the documents¶

The prepayment terms are in the loan term sheet or the loan summary, usually in the memorandum's financing section, and sometimes only in the risk factors. Five facts are worth writing down:

The structure: yield maintenance, defeasance, step-down, or a lockout followed by one of them.
The date the yield maintenance or lockout period ends, and the date the open period begins.
The exit year assumed in the pro forma, and whether it falls before those dates.
Whether projected sale proceeds are shown net of a prepayment premium, and what Treasury yield that premium assumes.
Whether the loan is assumable, and on what terms.

A projection that sells before the open period and shows no prepayment cost has left out a number. It may be a small number. The only way to know is to ask what yield it was calculated at, and to redo the arithmetic at a lower one.

Primary sources

Every factual claim above is traceable to a filing, a rule or an agency publication. These are the ones this article relies on.

Fannie Mae Multifamily Guide, yield maintenance prepayment premiumsmfguide.fanniemae.com
26 CFR 1.860G-2, REMIC qualified mortgages, including defeasancelaw.cornell.edu
Freddie Mac Multifamily, loan products and financing structuresmf.freddiemac.com
U.S. Treasury, daily par yield curve rateshome.treasury.gov
Federal Reserve, Financial Stability Report and commercial real estate exposuresfederalreserve.gov

Questions readers ask

What is a prepayment penalty on a commercial real estate loan?

A charge for repaying a loan before a date set in the loan documents. On fixed-rate multifamily and commercial loans it compensates the lender or bondholders for the interest they expected and will not receive.

How does yield maintenance work?

The borrower pays roughly the present value of the difference between the loan's interest rate and a Treasury yield over the remaining yield maintenance period, usually with a minimum. Fannie Mae's loan documents, for example, generally require the greater of 1% of the unpaid balance or yield maintenance.

What is defeasance?

Instead of repaying the loan, the borrower buys a portfolio of government securities whose payments cover the loan's remaining payments, and substitutes them as collateral. The loan stays outstanding and the property is released.

Why does the penalty get bigger when rates fall?

Because the lender is being compensated for reinvesting at a lower yield. The wider the gap between the loan rate and the current Treasury yield, the more interest there is to replace.

What should I look for in the offering documents?

The prepayment clause in the loan term sheet, when the yield maintenance or lockout period ends, when the open period starts, the exit year in the pro forma, and whether the projected sale proceeds are shown net of a prepayment premium.