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Prepayment penalties: step-down, yield maintenance, defeasance
· Concept
Fact, law or dataA rule, statute, definition or measured number.
Fees for paying off a fixed-rate property loan early, which make the lender or bondholders whole for the interest they lose.
See it on the Money & Finance map →How it works
Step-down: a percentage of the balance that falls each year, such as 5-4-3-2-1. Yield maintenance: the present value of the gap between the loan rate and today's Treasury yield over the remaining term. Example: $10 million at 6% with five years left and Treasuries at 4% costs roughly $0.9 million. Defeasance: the borrower buys Treasuries that cover every remaining payment and substitutes them as collateral. Most loans allow penalty-free payoff in the last three to six months.
Why it matters
The penalty often decides whether selling or refinancing pays. When market rates exceed the loan rate, yield maintenance falls to its floor, often 1%, and defeasance can cost less than the balance.
Facts, rules and data
Loan documents, defeasance consultants' cost calculators, the Fed's H.15 Treasury yields, and REMIC tax rules limiting early payoff of CMBS loans.
Inside this (2)
Connections (3)
▸Swap breakage: the cost (or refund) of unwinding a swap early acts as a hidden form of Prepayment penalties: step-down, yield maintenance, defeasanceMainstream view
The connection
A swap loan may advertise no prepayment penalty, but breaking the swap works like yield maintenance: both pay the lender's loss when rates have fallen, using the same present-value math. The difference: yield maintenance never pays the borrower, while swap breakage pays the owner when rates have risen.
When and why
In US bank loans fixed with swaps, sold widely to smaller borrowers from the 2000s on.
How solid is the link?
ISDA termination and yield-maintenance formulas are the same discounting calculation; the UK regulator's 2012–16 review flagged poorly explained swap exit costs.
Debates and risks
How well banks explained exit costs to small borrowers was the core issue in the UK review; whether US borrowers were similarly misled is debated.
▸Prepayment penalties: step-down, yield maintenance, defeasance are strictest in CMBS: conduit loans pooled into commercial mortgage bondsFact, law or data
The connection
CMBS bondholders bought a fixed stream of payments, and REMIC tax rules limit how the trust can change loans. So conduit loans usually bar prepayment for about two years after securitization, then require defeasance or yield maintenance until a short open window before maturity.
When and why
Standard in US conduit loans since the 1990s; the REMIC rules date from the Tax Reform Act of 1986.
How we know
CMBS loan agreements, Treasury REMIC regulations allowing defeasance only after two years, and defeasance cost data.
Debates and risks
Defeasance fees vary widely among consultants and servicers, and borrowers often cannot see how the servicer's charges are set.
▸Prepayment penalties: step-down, yield maintenance, defeasance are usually lighter, step-down style, in Bank balance-sheet loans from community and regional banksFact, law or data
The connection
Banks hold their loans and fund with deposits, so they lose less when a loan pays off early. Their fixed loans usually carry a step-down penalty, such as 3-2-1 on a five-year loan or 5-4-3-2-1 on a ten-year; floating loans are often free to prepay. A swap loan's breakage cost, though, works like yield maintenance.
When and why
Common practice at US community and regional banks; terms are negotiated loan by loan.
How we know
Bank term sheets and loan agreements.
Debates and risks
Penalties are negotiable; whether a lower rate with a stiffer penalty is the better trade depends on how long the owner holds.