How does a step-down prepayment penalty work?

What is a step-down prepayment penalty?

A Step-Down (or graduated) prepayment penalty is a penalty for paying off a commercial mortgage before the end of its loan term that decreases over time, typically structured in yearly decrements, like a 5-4-3-2-1% schedule of the outstanding balance. This structure incentivizes borrowers to hold onto the loan longer, reducing the lender's risk of early payoff and loss of interest income. It offers a simpler and more predictable alternative to other prepayment penalties, providing borrowers with increasing financial flexibility as the loan matures.

How is Step-Down Prepayment Penalty Calculated?

Step-down prepay penalties are calculated based on a predetermined percentage of the outstanding loan balance, decreasing annually according to a set schedule outlined in the loan agreement. This penalty percentage is applied to the remaining loan balance at the time of prepayment. For example, in a 5-4-3-2-1% step-down schedule, prepaying the loan in the first year incurs a penalty of 5% of the outstanding balance, 4% in the second year, and so on, until it phases out. The exact penalty amount depends on both the specific percentage applicable at the time of prepayment and the current outstanding loan balance.