What Is a Step-Down Prepayment Penalty?

A step-down, declining, or graduated prepayment penalty is a risk mitigation tool employed by lenders in commercial real estate finance. To hedge against the loss of interest earnings during a loan’s term, commercial mortgage lenders may include a step-down clause in a mortgage contract. This is usually a straightforward declining payment schedule based on the remaining balance at prepayment combined with the amount of time passed since the loan’s origination — or the last rate reset. The step-down prepayment penalty gets its name from the gradual reduction of the penalty as a loan gets closer to maturity.

Though there are many configurations of step-down schedules, an example of a typical step-down penalty structure is the 5-4-3-2-1 schedule, which, for a five-year loan term, makes the borrower responsible for paying a penalty of 5% of the outstanding balance if prepaying in the first year, 4% in the second year, 3% in the third year, and so on. Another common step-down structure for a five-year loan term is the 3-1-1, which only penalizes the borrower if the debt is prepaid within the first three years of the term. Many lenders do not impose a step-down penalty in the final 90 days of a loan’s term.

Alternatives to Step-Down Prepayment

• Learn about Defeasance

• Learn about Yield Maintenance