Rates & InterestLetter P

Prepayment Penalty (Step-Down & Hard/Soft)

A contractual fee clause in commercial, DSCR investor, and non-QM loans that charges the borrower a percentage fee if the loan is paid off or refinanced within an initial lock-out window.

Overview & Practical Application

A Prepayment Penalty is a contractual covenant in a loan agreement that assesses a fee if the borrower pays off all or a substantial portion of the mortgage principal early (typically through refinancing or selling the property) during the first 1 to 5 years of the loan.

Consumer Protection vs. Investor Loans: - Under the Dodd-Frank Act and CFPB Qualified Mortgage (QM) rules, prepayment penalties are strictly prohibited on almost all standard consumer primary-residence mortgages (FHA, VA, USDA, and Conforming Fannie/Freddie loans), as well as all student loans and federal credit union auto loans. - Conversely, prepayment penalties are standard practice on DSCR Investor Mortgages, Commercial Real Estate (CRE) loans, and Non-QM loans, where investors routinely accept a 3-year or 5-year Step-Down Prepayment Penalty (such as 5-4-3-2-1 or 3-2-1) in exchange for a 0.25% to 0.50% lower interest rate.

Types of Step-Down Penalties: - Hard Prepayment Penalty: Triggered whether the borrower refinances the loan OR sells the property. - Soft Prepayment Penalty: Triggered *only* if the borrower refinances the loan; waived if the property is sold in an arm’s-length sale.

Mathematical Formula & Calculation

Step-Down Prepayment Fee ($) = Remaining Principal Balance * Active Year Penalty %

Multiplies the unpaid loan balance at the time of early payoff by the step-down percentage applicable to that loan year (e.g., 3% in Year 1, 2% in Year 2, 1% in Year 3, 0% in Year 4+).

Variable Definitions:

Remaining Principal Balance=Outstanding loan payoff balance (often allowing a 20% annual penalty-free curtailment)
Active Year Penalty %=Contracted step-down percentage for the current anniversary year of the note

Real-World Underwriting Example

Scenario: An investor holds a $400,000 DSCR rental mortgage with a "3-2-1 Step-Down" prepayment penalty (3% Year 1, 2% Year 2, 1% Year 3, 0% Year 4+). They refinance in Month 18 (Year 2).

Calculation:

Year 2 Penalty Rate = 2.00%.
Prepayment Fee = $400,000 * 0.02 = $8,000.

Takeaway: Refinancing in Year 2 adds an $8,000 prepayment fee to the payoff statement; waiting until Month 37 (Year 4) reduces the penalty to $0.

Key Underwriting Takeaways

Standard primary-residence FHA, VA, USDA, and Conforming mortgages have ZERO prepayment penalties by federal law.
Real estate investors taking DSCR loans can choose between a 0-year, 3-year (3-2-1), or 5-year (5-4-3-2-1) prepayment structure depending on their planned hold horizon.
Most commercial/DSCR notes allow you to pay down up to 20% of the principal balance per year completely penalty-free.

Overview & Practical Application

Mathematical Formula & Calculation

Variable Definitions:

Real-World Underwriting Example

Key Underwriting Takeaways

Related Financial Terms

Yield Maintenance Prepayment Defeasance

Debt Service Coverage Ratio (DSCR)

Loan Refinancing

Amortization

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