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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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.

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.

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, especially if the loan is prepaid in the first few years of the term. For example, a 5-4-3-2-1 step-down penalty structure 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, 3% in the third year, and so on. This can be a significant cost for borrowers.

The alternatives to a step-down prepayment penalty are Defeasance and Yield Maintenance. Learn more about Defeasance and Yield Maintenance.

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.