Yield Maintenance vs Defeasance vs Step-Down: Apartment Loan Prepayment Penalties Explained
Most fixed-rate apartment loans charge a prepayment premium if the borrower pays off the loan early. Yield maintenance pays the lender roughly the interest it loses when rates have fallen, defeasance replaces the property as collateral with government securities that keep making the payments, and a step-down charges a fixed percentage of the balance that declines each year. Which one a loan uses, and how long it lasts, often decides when a syndication can sell or refinance, so read the loan terms before you invest.
Why do apartment loans have prepayment penalties?
A lender or bond investor that funds a fixed-rate loan expects a stream of payments for the full term. If you pay early when rates have fallen, the lender must reinvest at a lower rate. The prepayment premium compensates for that. Agency loans that are pooled into securities need predictable cash flows for bondholders, which is why their prepayment terms are strict.
How do the three structures compare?
| Feature | Yield maintenance | Defeasance | Step-down |
|---|---|---|---|
| What you pay | A premium based on the difference between the loan rate and a Treasury yield over the remaining term | The cost of a portfolio of government securities that replaces the loan's remaining payments, plus third-party costs | A set percentage of the balance, lower each year |
| Depends on rates at payoff? | Yes | Yes | No |
| Loan is paid off? | Yes | No, the loan stays outstanding with new collateral | Yes |
| Often used on | Fannie Mae fixed-rate loans; Freddie Mac fixed-rate loans before securitization | Securitized fixed-rate loans after a lock-out | Floating-rate loans and some small-balance loans |
| Easy to estimate? | Needs a calculation | Needs a quote | Yes |
Sources: Fannie Mae conventional term sheet, Freddie Mac fixed-rate term sheet, Freddie Mac floating-rate term sheet and small balance term sheet. Each loan's documents control, and term sheets change.
How does yield maintenance work?
Yield maintenance asks: how much interest would the lender lose by reinvesting the payoff at today's Treasury yield instead of earning the loan's rate through the end of the yield maintenance period? The loan documents set the exact formula, including which Treasury yield, how payments are discounted and any minimum premium.
A made-up example. A deal has an $8,000,000 interest-only loan at 6.0% with 5 years left in the yield maintenance period. At payoff, the matching Treasury yield is 4.0%. The lender loses 2.0% a year on $8,000,000, or $160,000 a year for 5 years. Discounted at 4.0% a year, that stream is worth about $712,000. That is the rough premium. If the Treasury yield were 6.0% or higher at payoff, the premium would fall to whatever minimum the note sets, if any.
The example simplifies (annual payments, no amortization), but it shows the key point: yield maintenance is expensive when rates fall after closing and cheap when rates rise.
How does defeasance work?
With defeasance, the borrower does not pay off the loan. It buys a portfolio of government securities whose payments match the remaining loan payments, pledges them to the lender as substitute collateral, and the lien on the building is released so it can be sold or refinanced. A successor borrower takes over the loan and the securities.
Defeasance is common on loans held in real estate mortgage investment conduits (REMICs), the structure many commercial mortgage securities use. Treasury regulations allow a REMIC to release its lien through defeasance only if the substitute collateral is government securities, the release is to facilitate a sale or similar customary transaction, and it is not within 2 years of the REMIC's startup day (26 CFR 1.860G-2(a)(8)). That is one reason securitized loans carry a lock-out followed by defeasance.
Like yield maintenance, defeasance costs more when Treasury yields are below the loan rate, because more securities are needed to produce the same payments. Expect added costs for a consultant, legal work and the successor borrower.
How does a step-down work?
A step-down sets a percentage of the balance for each year. Freddie Mac's floating-rate term sheet lists options such as 5%, 4%, 3%, 2%, 1%, 1%, 1%, 1% across eight years, with no premium in the last 90 days.
A made-up example. Using that schedule on an $8,000,000 balance, a sale in year 3 would cost 3%, or $240,000, whatever rates have done. Step-downs are easy to underwrite because the cost does not depend on rates.
Why does this shape exit timing?
The prepayment terms often decide the best window for a sale or a cash-out refinance. A few patterns to look for:
- A planned sale in year 3 to 5 on a 10-year fixed loan means paying yield maintenance or defeasance. The model should include an estimate at more than one interest rate.
- A loan that can be assumed by a buyer avoids the premium, but the buyer and lender must agree, and the price may reflect the loan's rate. See whether a syndication can assume a seller's loan.
- The final 90 days of many agency loans carry no premium, which can make a sale near maturity cheaper.
- HUD-insured loans follow their own rule: the National Housing Act generally bars prepayment of a Section 223(f) loan for 5 years from endorsement. See HUD 223(f) loans.
Floating-rate loans usually have lighter prepayment terms but need an interest rate cap. The bridge versus agency loan guide covers that trade.
What should you ask the sponsor?
- What prepayment structure does the loan use, and for how long?
- What premium does the model assume at the planned exit, and at what Treasury yield?
- What happens to returns if rates fall by one percentage point before the sale?
- Is the loan assumable, and on what terms?
How DoorRaise fits in
DoorRaise helps sponsors raise equity for apartment buildings with 5 or more units under Rule 506(b) or 506(c). It prepares the standard offering documents, files Form D and state notices, and holds investor funds in escrow at Enterprise Bank & Trust, an FDIC-insured bank. DoorRaise does not arrange loans or calculate prepayment premiums; the loan terms on a deal page come from the sponsor and its lender.
Raise your apartment deal from the people who already follow you.
DoorRaise is built for apartment buildings with 5 or more units: one link for the deal, escrow until closing and a standard fee card.
See how it works for the investor steps.
FAQ
Is yield maintenance the same as a prepayment penalty?
It is one kind. "Prepayment penalty" or "prepayment premium" is the general term; yield maintenance is a specific formula tied to interest rates.
Can defeasance ever be cheaper than yield maintenance?
It depends on the formulas, the rates at payoff and the third-party costs. Get quotes for the actual loan rather than relying on a rule of thumb.
Do investors pay the prepayment premium?
The deal pays it, usually from sale or refinance proceeds, so it reduces what investors receive.
Why would a sponsor accept yield maintenance?
A fixed rate locks in the payment for the term, which can suit a long hold. The trade is less flexibility on timing.
Next step: read multifamily underwriting basics to see how the loan fits the rest of the numbers.
Sources
- Fannie Mae Multifamily, Conventional Properties term sheet
- Freddie Mac Multifamily, Optigo Fixed-Rate Loans term sheet
- Freddie Mac Multifamily, Optigo Floating-Rate Loans term sheet
- Freddie Mac Multifamily, Optigo Small Balance Loans term sheet
- 26 CFR 1.860G-2, REMIC qualified mortgages, including defeasance
- HUD, Multifamily Accelerated Processing (MAP) Guide
This article is general information, not legal, tax or investment advice. Talk to your own attorney and lender about specific loan terms before you invest. DoorRaise is not a law firm, broker-dealer, investment adviser or funding portal.