Prepayment is paying off a loan balance before maturity (the end of the loan term). Most HUD multifamily loans have a two-year lockout (a period in which the borrower cannot repay the loan at all), followed by an 8-1% declining prepayment penalty. For example, if a borrower wanted to prepay the loan in the third year, they would face an 8% penalty, in the fourth year, a 7% penalty, and after the tenth year, they could prepay the loan with no penalty at all.

A prepayment penalty is a type of fee charged to a borrower who pays off a loan before the maturity date. With most commercial real estate loans, the borrower is expected to pay interest on the principal loan amount. The interest that the borrower pays represents compensation to the lender for the use of its money over a period of time, essentially dictating the lender’s rate of return. The way most commercial loans are structured, when a borrower is able to pay the loan in full ahead of schedule — without prepayment penalties in place — the lender stands to lose out on the interest that would have been earned monthly over the life of the loan.

The main benefit of prepayment is that it allows borrowers to pay off their debt early and no longer have to worry about it. This can be a great way to save money on interest payments, as the borrower will no longer have to pay the interest rate on the loan. Additionally, with step-down prepayment, the borrower agrees to pay a lower interest rate on the balance in order to prepay the loan. The premium amount depends on how far into the loan term the borrower is, and typically reduces as the maturity date gets closer. Finally, with bridge loans, prepayment is usually simple and does not have prepayment penalties attached. This adds to their flexibility, as borrowers can repay their bridge loan immediately at no cost beyond the loan's balance.

The main risk associated with prepayment is that the lender is denied their expected interest payments when the loan is paid in full before reaching its maturity date. This can be a significant amount of money, especially if the loan was for a large amount and had a long term. Lenders view prepayment as a risk and often implement prepayment penalties as a way to protect themselves. Prepayment penalties often exist as a fee that borrowers have to pay if they want to prepay their loans. Beyond charging a simple or flat fee as a penalty, there are also more complex forms of prepayment penalties that are aimed at giving the lender a more fair return should the debt be paid off before fully maturing.

Source: www.commercialrealestate.loans/commercial-real-estate-glossary/Prepayment-Risk-in-Commercial-Real-Estate

The three main types of prepayment options are defeasance, yield maintenance, and step-down prepayment.

Defeasance involves replacing the loan with a portfolio of government securities. Learn more about Defeasance.

Yield maintenance is a penalty that is designed to make the lender whole for the lost interest income. Learn more about Yield Maintenance.

Step-down prepayment involves a straightforward declining payment schedule — 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. The step-down moniker comes from the gradual reduction of the penalty borrowers are expected to pay as the loan matures. Learn more about Step-Down Prepayment.

Prepayment of a commercial real estate loan can have a significant effect on the borrower. Lenders often employ risk mitigation strategies such as lockout periods and prepayment penalties to protect themselves from losses due to prepayment. Lockout periods prevent the loan from being prepaid until a specified amount of time has passed, while prepayment penalties require the borrower to compensate the lender for missed interest payments in one way or another. Depending on the risk mitigation technique employed, borrowers may find it time-consuming and/or costly when exiting a commercial mortgage early.

For more information on prepayment penalties, please see Understanding Prepayment Penalties.