There is quite a bit of confusion among borrowers and brokers regarding the various types on penalties for exiting a loan prior to the end of the loan term.

Why are exit penalties important to borrowers?
When evaluating any lending decision it is critical that borrowers understand the total cost of a loan. This total cost should include appraisals (inspection fees), broker fees, lender upfront fees, and exit fees. Exit fees are typically not factored in by borrowers since they are not paying the fees now. This can be a very costly mistake for a borrower to make. Below each of the various fees are discussed so that borrowers can understand the true costs of the loan.

Why are exit penalties important to lenders?
Exit fees are critical for lenders in that they enable the loan to be placed into a security. When loans are securitized buyers of the securities need some assurance that the loans will stay outstanding for a certain period of time. This enables them to be relatively certain on the yield they will receive from a certain security.

What are the various types of penalties for exiting a loan early?
There are four primary types of exit penalties used by lenders: prepayment penalty (exit fee), Interest Guarantee, Lockout, and Defeasance.

• Prepayment Penalty (exit fee):
  This is the simplest of the prepayment penalties, it is calculated by taking the current outstanding balance and multiplying this amount by the prepayment penalty. For example on a $100k loan, if the loan were repaid in year 2 (assuming a 3/2/1 exit) the exit fee would be $~2k (assuming an interest only loan w/ no principal reduction)
• Interest Guarantee:
  This states that the lender is entitled to the interest over a certain period of time even if the loan is paid off early. For example if a lender charges a 10% interest rate on a $100k loan (assuming interest only loan). Also assume that the interest guarantee states that the lender has a 60 month interest guarantee and a 5% exit fee thereafter. If a borrower were to pay off at the beginning of month thirteen, the lender would be entitled to 48 months of interest. In this example the exit fee would be ~ $40k; this is substantially higher than the prepayment penalty above. Many stated lenders utilize the interest guarantee.
• Lockout:
  This states that the borrower is not allowed to pay the loan off within a certain period of time, for example it might state that there is a 5 year lockout. The borrower could not pay the loan off within 5 years.
• Defeasance:
  Real Estate Weekly defines defeasance as a substitution of collateral. Typically, the borrower uses proceeds from a refinance or sale to purchase a portfolio of U.S. government securities that is sufficient to make all of the remaining debt service payments required by the note. The securities are pledged to the lender, and the lender releases the real estate from the lien of the mortgage. The note remains outstanding but is assigned by the borrower to an unaffiliated successor borrower, who makes the ongoing debt service payments. The penalties associated with paying off a loan that has been securitized in the secondary market can be extremely expensive. The penalty can be calculated at: www.defeasewithease.com or any other number of websites. In this paper we will not discuss the calculation of defeasance due to the number of assumptions needed and the complexity.

Most private commercial lenders or stated commercial lenders typically utilize the top three methods above (prepayment, interest guarantee, and lockout) or a combination of a number of these items. As one can see from the calculation it is imperative for borrowers to understand the true cost of their loan. For example if a borrower were to take out a loan that had a simple exit fee (as in the example above) versus a loan with an interest guarantee, the borrower would be paying the lender ~ $32k more. Even if the lender offering the prepayment penalty had a rate of 4% higher, the borrower would still save substantial money. Understanding the total cost of a loan is critical to ensuring that a borrower is making the correct financial decision.