DSCR Loan Prepayment Penalties: What to Watch For

About 60-70% of DSCR loans include prepayment penalties, a feature that's nearly extinct in conventional residential mortgages. These penalties can cost you thousands—or even tens of thousands—if you sell, refinance, or pay off your loan early.

Understanding exactly how these penalties work, when they apply, and how to evaluate whether accepting one makes financial sense is critical before you sign your loan documents.

What Is a DSCR Loan Prepayment Penalty?

A prepayment penalty is a fee charged by the lender if you pay off your loan before a specified period ends. It compensates the lender for lost interest income when you terminate the loan early.

Common structures:

• 3-year penalty: You pay a fee if you pay off the loan within the first 3 years
• 5-year penalty: Fee applies if paid off within 5 years
• Step-down penalty: Fee decreases each year (e.g., 5% year 1, 4% year 2, 3% year 3, 2% year 4, 1% year 5)

The penalty typically applies to refinances, sales, or large principal paydowns exceeding 20% of the original loan amount annually.

Why DSCR Loans Have Prepayment Penalties

Unlike conventional mortgages (which are usually sold to Fannie Mae or Freddie Mac), DSCR loans are typically held in portfolio or securitized into private mortgage-backed securities.

For portfolio lenders: They expect to earn interest over a certain period to justify the origination costs and capital allocation. Early payoff disrupts their return projections.

For securitized loans: Investment pools promise bondholders specific returns over specific timeframes. Prepayments reduce those returns, making prepayment penalties necessary to maintain the security's value.

Rate buydown trade-off: Many lenders offer 0.25-0.75% lower rates if you accept a prepayment penalty. The penalty ensures they recover expected interest even if you pay off early.

Common DSCR Prepayment Penalty Structures

Fixed Percentage Penalty

The penalty is a fixed percentage of the outstanding loan balance.

Example: 3% penalty for 3 years

• Year 1: Pay off a $400,000 loan = $12,000 penalty
• Year 2: Pay off $380,000 remaining = $11,400 penalty
• Year 3: Pay off $360,000 remaining = $10,800 penalty
• Year 4+: No penalty

This structure is simple and predictable. You know exactly what you'll pay if you exit early.

Step-Down Penalty

The penalty decreases each year.

Example: 5-4-3-2-1 structure on a $400,000 loan

• Year 1: 5% = $20,000
• Year 2: 4% = $15,200 (on remaining $380,000)
• Year 3: 3% = $10,800 (on remaining $360,000)
• Year 4: 2% = $6,800 (on remaining $340,000)
• Year 5: 1% = $3,200 (on remaining $320,000)
• Year 6+: No penalty

Step-down penalties are borrower-friendly compared to flat penalties, but they're typically paired with longer penalty periods.

Yield Maintenance

The penalty equals the present value of remaining interest payments, calculated using the difference between your rate and current Treasury rates.

Formula: Remaining balance × (your rate - current Treasury yield) × remaining months in penalty period ÷ 12

Example:

• Loan balance: $400,000
• Your rate: 8%
• Current 5-year Treasury: 4.5%
• Months remaining in penalty: 36

Penalty = $400,000 × (8% - 4.5%) × (36÷12) = $400,000 × 3.5% × 3 = $42,000

Yield maintenance penalties can be enormous when interest rates drop significantly. If rates rise instead, the penalty might be minimal or even waived.

Defeasance

Used primarily in commercial DSCR loans ($1M+), defeasance requires you to replace your loan collateral with Treasury securities that generate equivalent cash flows to your remaining payments.

Example: You want to pay off a $2M loan with 7 years remaining. You must purchase Treasury bonds generating the same payment stream and pledge those to the lender.

Defeasance is complex and expensive, typically costing 1-3% of the loan balance in fees beyond the Treasury security purchase. Most investors avoid loans with defeasance penalties.

Soft vs Hard Prepayment Penalties

Soft penalty: Applies only to refinances, not sales

• You can sell the property without penalty
• Refinancing triggers the penalty
• Common in investor-friendly DSCR products

Hard penalty: Applies to any payoff—sale, refinance, or lump sum payment

• Most restrictive for borrowers
• Common when you've received significant rate discounts for accepting the penalty

Always confirm whether your penalty is soft or hard. The difference can be $15,000+ on a $500,000 loan if you need to sell.

How Prepayment Penalties Affect Rates

Accepting a prepayment penalty typically earns you a rate reduction:

No penalty: 8.50% (base rate) 3-year penalty: 8.25% (0.25% reduction) 5-year penalty: 8.00% (0.50% reduction)

The rate reduction increases with longer penalty periods and higher penalty percentages.

Is the Rate Reduction Worth It?

Run the math for your specific situation:

Example: $400,000 loan, planning to hold 10+ years

Option A (no penalty): 8.50% = $3,076/month Option B (5-year penalty, 3% of balance): 8.00% = $2,935/month Monthly savings: $141 Total savings over 5 years: $8,460

If you sell in year 4, the penalty is ~$10,800 (3% of ~$360,000 remaining). You've saved $6,768 in payments (48 months × $141), so you're net negative $4,032.

If you hold beyond year 5, you keep saving $141/month forever—$16,920 over 10 years, $25,380 over 15 years.

Verdict: Accept the penalty if you're highly confident in holding 5+ years. Otherwise, the risk isn't worth the savings.

What Triggers Prepayment Penalties

Most DSCR prepayment penalties trigger on:

Full Loan Payoff

• Selling the property
• Refinancing to a new loan
• Paying off the loan with other funds

Partial Payoffs Above Threshold

Most loans allow 10-20% of the original principal to be prepaid annually without penalty. Exceeding that threshold triggers a penalty on the excess.

Example: $400,000 loan with 20% annual prepayment allowance

• Year 1: Pay down $60,000 = $20,000 penalty-free (20% of original $400,000)
• The extra $40,000 might incur a penalty (3% = $1,200)

Assumption or Transfer

Transferring the loan to a new borrower (loan assumption) often triggers the penalty, even though the loan isn't being paid off.

Foreclosure or Short Sale

In most states, prepayment penalties apply even in foreclosure. If the lender forecloses and sells the property, they may deduct the penalty from any excess proceeds or add it to your deficiency judgment.

A few states (California, for example) prohibit prepayment penalties in foreclosures, but most allow them.

What Usually Doesn't Trigger Penalties

Extra Monthly Payments Within Limits

Making additional principal payments up to the annual threshold (typically 20%) doesn't trigger penalties.

Strategy: If you have excess cash flow, prepay up to the threshold each year to reduce principal without penalty.

Borrower Death

Most loans waive prepayment penalties if the borrower dies and the estate pays off the loan.

Insurance Claim Payoff

If the property is destroyed and insurance proceeds pay off the loan, penalties are usually waived.

Assumption to Family Member

Some lenders waive penalties for transfers to immediate family (spouse, children) though this isn't universal.

State Laws and Prepayment Penalties

Some states restrict or prohibit prepayment penalties:

States with restrictions:

• California: Limits penalties to 6 months interest, and they can't extend beyond year 5 on certain loan types
• Minnesota: Prohibits penalties exceeding 2% of prepaid amount
• Michigan: Restricts penalties on certain residential mortgages
• Massachusetts: Limits enforcement

States with few restrictions: Most states allow prepayment penalties on investment properties without limitation. Since DSCR loans are for non-owner-occupied properties, consumer protection laws rarely apply.

Check your state: Before accepting a penalty, verify whether your state limits enforceability. Your real estate attorney can confirm.

Negotiating Prepayment Penalty Terms

Prepayment penalties are often negotiable:

Reduce the Penalty Percentage

If the lender offers a 5% penalty, counter with 3%. They might accept 4% as a compromise while still reducing your rate by 0.375% instead of 0.50%.

Shorten the Penalty Period

Counter a 5-year penalty with a 3-year penalty. You might get 0.25% rate reduction instead of 0.50%, but the shorter timeline reduces risk.

Request a Soft Penalty

If the lender insists on a penalty, ask for it to be "soft" (refinance only, not sale). This gives you an exit if you need to sell but keeps the lender's refinance protection.

Negotiate a Step-Down Structure

Instead of flat 3% for 3 years, propose 3-2-1. You get partial rate reduction benefits while limiting downside if you exit in year 2 or 3.

Build in Exception Clauses

Ask for penalty waivers in specific situations:

• Property value declining more than 20%
• Extended vacancy (6+ months)
• Major repairs exceeding 10% of property value
• Eminent domain taking

Lenders won't always agree, but it costs nothing to ask.

Strategies to Avoid or Minimize Penalties

Choose No-Penalty Loans

Many DSCR lenders offer no-penalty options. You'll pay 0.25-0.75% higher rates, but you eliminate exit risk.

When this makes sense:

• You're uncertain about holding period
• The property is in a volatile market
• You're a serial refinancer who optimizes rates aggressively
• You're investing in an appreciating market where values might spike quickly

Plan Around the Penalty Period

If you accept a 3-year penalty, plan your exit strategy for month 37 or beyond. Don't sell in month 35 and pay $12,000 unnecessarily.

Partial Paydowns Stay Under Threshold

If you receive a windfall and want to pay down principal, keep it under the annual threshold (typically 20% of original balance). You'll avoid penalties while still reducing interest.

Port the Loan

Some portfolio lenders allow you to "port" the loan to a new property. You sell property A, use proceeds to buy property B, and transfer your existing DSCR loan to property B.

This is rare in DSCR lending but worth asking about if you plan to sell and immediately reinvest.

Refinance Before the Property Appreciates Significantly

If you're in an appreciating market, refinance before prices surge. Once you build equity, you're more likely to want to refinance to pull cash out—but that triggers the penalty.

Refinancing early (while the penalty is in effect but before you have compelling reason) might not make financial sense, but it's a consideration.

Red Flags in Prepayment Penalty Clauses

Vague Language About What Triggers Penalty

The loan documents should explicitly state what actions trigger the penalty. If language is vague ("borrower actions that reduce lender returns"), that's problematic.

Red flag example: "Any prepayment or action reducing the loan balance" This could theoretically include insurance claims or property tax appeals that reduce the collateral value. Insist on specific triggering events.

Penalties Extending Beyond 5 Years

Residential investment property prepayment penalties beyond 5 years are unreasonable. If a lender wants a 7-10 year penalty, that's a commercial loan structure—you should be getting commercial loan rates (lower than DSCR rates).

No Cap on Yield Maintenance Penalties

Yield maintenance penalties can theoretically exceed your loan balance if rates drop dramatically. Insist on a cap (e.g., "not to exceed 5% of remaining balance").

Penalties That Apply to Involuntary Payoff

If the lender can charge a penalty when they foreclose on you, that's adding insult to injury. Some states prohibit this; in states that don't, negotiate it out of your loan terms.

Calculating Your Breakeven Point

Before accepting a prepayment penalty, calculate your breakeven:

Inputs:

• Rate with penalty: 8.0%
• Rate without penalty: 8.5%
• Loan amount: $400,000
• Penalty: 3% of balance for 3 years

Calculation: Payment with penalty: $2,935/month Payment without penalty: $3,076/month Monthly savings: $141

After 36 months, you've saved $5,076 (36 × $141).

If you pay off the loan in month 36, the penalty is ~$10,980 (3% of ~$366,000 remaining balance).

Net cost of accepting penalty: $10,980 - $5,076 = $5,904 loss

You break even around month 78 (6.5 years) when cumulative savings equal the penalty paid.

Conclusion: Only accept this penalty if you're confident you'll hold beyond 6.5 years.

Prepayment Penalty Disclosure Requirements

Lenders must disclose prepayment penalties in multiple documents:

Loan Estimate (page 1): States whether a prepayment penalty exists and the amount Closing Disclosure (page 4): Details the penalty terms Promissory Note: Full penalty calculation methodology

Review all three to ensure consistency. If the Loan Estimate says "no prepayment penalty" but the Closing Disclosure includes one, stop the closing and clarify.

You have three business days after receiving the Closing Disclosure to review it before closing. Use that time—don't see a prepayment penalty for the first time at the closing table.

When Prepayment Penalties Make Sense

Despite the restrictions, prepayment penalties can be smart in these situations:

Long-term buy-and-hold strategy: If you're buying a stable rental in a strong market and plan to hold 10+ years, accepting a penalty for 0.50% rate reduction makes financial sense.

Portfolio building: Experienced investors who never sell (only refinance to pull equity) can accept penalties, wait out the period, then refinance to access equity.

Rate-sensitive scenarios: If the rate reduction drops your DSCR from 1.08 to 1.15, that might unlock better loan terms or give you more buffer for unexpected expenses.

You need the lower payment to qualify: If the lower rate is the difference between qualifying and not qualifying for the loan, accept the penalty and plan to hold long-term.

Bottom Line

DSCR loan prepayment penalties are more common and often more expensive than most borrowers expect. A seemingly small 3% penalty on a $400,000 loan costs $12,000 if you sell in year one.

Before accepting a penalty:

1. Calculate your breakeven point based on the rate savings
2. Assess your realistic hold period honestly—not optimistically
3. Negotiate for shorter periods, step-downs, or soft penalties
4. Ensure disclosure documents match across Loan Estimate, Closing Disclosure, and Note

The rate reduction is appealing, but only capture it if you're truly committed to long-term ownership. For investors who value flexibility over payment reduction, no-penalty DSCR loans are worth the extra 0.25-0.50% in interest rate.