Step-Down Prepayment Penalty
Step-down, or graduated, prepayment is a straightforward declining payment schedule that is calculated based on the remaining balance at prepayment in conjunction with the amount of time that has passed since the closing of the loan — or the most recent rate reset.
What Is a Step-Down Prepayment Penalty?
A step-down prepayment penalty is a risk mitigation strategy utilized by lenders in commercial real estate finance. Also known as a graduated or declining prepayment, step-down prepayment is used to hedge against the loss of interest earnings during a loan’s term. Step-down prepayment is named after the structure of the penalty — a simple 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, graduated, and declining monikers more specifically refer to the gradual reduction of the penalty as the loan gets closer to maturity.
Though many configurations of step-down prepayment schedules exist, an example of a more common step-down penalty structure for a five-year loan term is the 3-1-1, which penalizes the borrower with a 3% premium if the debt is prepaid within the first three years of the term, and then 1% if prepaid during either of the last two years of the term. Another common step-down structure is the 5-4-3-2-1 schedule. This structure, 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. It is common in the industry for lenders to not impose a step-down penalty in the final 90 days of a loan’s term.
Step Down Prepayment Pros
Relatively low cost (compared to other prepayment penalties) to exit a loan early.
Incredibly simple and straightforward process.
Predictable payment schedule.
Great option when interest rates are stagnant or declining.
The first step down tier can be set pretty high depending on the lender, making an extremely early exit less affordable.
Mostly found as an option for recourse loans.
Can be a poor option in a rising interest rate environment.
Susceptible to lock-out periods.
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What is a step-down prepayment penalty?
A step-down (or declining or graduated) prepayment penalty is a prepayment risk mitigation tool employed by lenders in commercial real estate. To insure against the loss of interest earnings during a loan’s full term, commercial mortgage lenders may include a step-down clause in a mortgage contract. Generally, this is a straightforward declining payment schedule based on the remaining balance at prepayment in conjunction with the amount of time passed since the loan was closed (or the last occurrence of a rate reset). The step-down prepayment penalty gets its name from the gradual reduction of the penalty as a loan matures.
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 5 year loan term, makes the borrower responsible for paying a penalty of 5% of the outstanding balance if prepaying the loan 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 last 90 days of a loan term.
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How does a step-down prepayment penalty work?
A step-down (or declining or graduated) prepayment penalty is a prepayment risk mitigation tool employed by lenders in commercial real estate. To insure against the loss of interest earnings during a loan’s full term, commercial mortgage lenders may include a step-down clause in a mortgage contract. Generally, this is a straightforward declining payment schedule based on the remaining balance at prepayment in conjunction with the amount of time passed since the loan was closed (or the last occurrence of a rate reset). The step-down prepayment penalty gets its name from the gradual reduction of the penalty as a loan matures.
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 5 year loan term, makes the borrower responsible for paying a penalty of 5% of the outstanding balance if prepaying the loan 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 last 90 days of a loan term.
What are the benefits of a step-down prepayment penalty?
The main benefit of a step-down prepayment penalty is that it provides lenders with a risk mitigation tool to insure against the loss of interest earnings during a loan’s full term. This type of penalty structure also provides borrowers with more flexibility in terms of prepayment options, as the penalty decreases over time. For example, a 5-4-3-2-1 step-down penalty structure for a 5 year loan term would make the borrower responsible for paying a penalty of 5% of the outstanding balance if prepaying the loan 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 last 90 days of a loan term.
You can learn more about Step-Down Prepayment Penalty and Commercial Real Estate Loans.
What are the drawbacks of a step-down prepayment penalty?
The main drawback of a step-down prepayment penalty is that it can be difficult to predict the exact amount of the penalty. This is because the penalty is based on the remaining balance at prepayment in conjunction with the amount of time that has passed since the loan was closed or the last occurrence of a rate reset. Additionally, the penalty amount can be quite high if the loan is prepaid in the first few years of the term. For example, a 5-4-3-2-1 schedule for a 5 year loan term would require the borrower to pay a penalty of 5% of the outstanding balance if the loan is prepaid in the first year, 4% in the second year, and so on. This can be a significant cost for borrowers who need to prepay their loan early.
How can I calculate the cost of a step-down prepayment penalty?
The cost of a step-down prepayment penalty is calculated based on the remaining balance at prepayment in conjunction with the amount of time that has passed since the closing of the loan or the most recent rate reset. Generally, the penalty is a straightforward declining payment schedule. For example, a 5-4-3-2-1 schedule for a 5 year loan term would make the borrower responsible for paying a penalty of 5% of the outstanding balance if prepaying the loan 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 last 90 days of a loan term. Learn more about Step-Down Prepayment Penalty.
Are there alternatives to a step-down prepayment penalty?
Yes, there are alternatives to a step-down prepayment penalty. Two of the most common alternatives are Defeasance and Yield Maintenance.
Learn more about Defeasance and Yield Maintenance.