When you’re shopping for a DSCR loan, the interest rate gets most of the attention. But there’s another number that can have an even bigger impact on your returns: the prepayment penalty. Choose the wrong structure, and you could face a five-figure fee when you sell or refinance your property. Choose wisely, and you’ll have the flexibility to adapt to market changes without unnecessary costs.
This guide breaks down how DSCR loan prepayment penalties work, the common structures you’ll encounter, and how to choose the right option based on your investment timeline.
What Is a 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 the interest income they expected to earn over the loan term.
Think of it from the lender’s perspective: they invest significant resources to originate your loan—underwriting, appraisals, legal documentation, and capital allocation. They expect to recoup that investment and earn a return through years of interest payments. When you pay off early, they lose that expected income.
The tradeoff for borrowers is straightforward: longer prepayment penalties typically mean lower interest rates. Lenders offer better pricing when they have more certainty about how long they’ll earn interest on the loan.
When Does the Prepayment Penalty Apply?
The penalty is triggered when you pay off all or a substantial portion of the loan principal before the penalty period expires. Common triggers include:
- Selling the property: The most common scenario—proceeds from the sale pay off the loan
- Refinancing: Taking out a new loan to replace the existing one
- Paying down principal: Making extra payments that exceed the allowed threshold (typically 20% of original principal per year)
- Loan acceleration: Prepayment resulting from default or foreclosure may also trigger the penalty
Important: Most DSCR loans allow partial prepayments up to 20% of the original principal balance per year without triggering the penalty. Check your loan documents for the specific threshold.
Common DSCR Loan Prepayment Penalty Structures
DSCR lenders typically offer two main prepayment structures, with variations in duration. Understanding each helps you choose the option that aligns with your investment timeline.
Fixed Percentage Structure
With a fixed percentage structure, the penalty remains the same throughout the entire prepayment term. The most common version is a 5% fixed penalty that applies regardless of which year you exit.
How it works: If you choose a 3-year prepayment term with 5% fixed, you’ll pay 5% of the outstanding balance whether you exit in Year 1, Year 2, or Year 3. After Year 3, no penalty applies.
- Year 1: 5% of outstanding loan balance
- Year 2: 5% of outstanding loan balance
- Year 3: 5% of outstanding loan balance
- Year 4+: No penalty
Example: On a $400,000 loan balance with a 5-year fixed prepayment, selling in Year 1 costs $20,000 (5%), and selling in Year 4 also costs $20,000 (5%). The penalty only disappears after the full term expires.
Best for: Long-term buy-and-hold investors who are confident they’ll hold the property past the prepayment term. You typically get the lowest interest rate in exchange for this structure.
Declining (Step-Down) Structure
A declining structure reduces the penalty percentage over time. However, not all declining structures are created equal—some step down more aggressively than others.
5-4-3-3-3 Structure (Common with 3% Floor)
Many DSCR lenders use a declining structure that starts at 5% but has a floor of 3%—meaning the penalty won’t drop below 3% during the prepayment term.
- Year 1: 5% of outstanding loan balance
- Year 2: 4% of outstanding loan balance
- Year 3: 3% of outstanding loan balance
- Year 4: 3% of outstanding loan balance (floor)
- Year 5: 3% of outstanding loan balance (floor)
- Year 6+: No penalty
Example: On a $400,000 loan balance, selling in Year 1 costs $20,000 (5%), Year 3 costs $12,000 (3%), and Year 5 still costs $12,000 (3% floor).
Best for: Investors who want some rate benefit from a longer term but appreciate the reduced penalty in later years. The 3% floor still represents a meaningful cost, so plan accordingly.
5-4-3-2-1 Structure (Industry Standard Step-Down)
Some lenders in the DSCR space offer a more aggressive step-down that continues declining each year:
- Year 1: 5% of outstanding loan balance
- Year 2: 4% of outstanding loan balance
- Year 3: 3% of outstanding loan balance
- Year 4: 2% of outstanding loan balance
- Year 5: 1% of outstanding loan balance
- Year 6+: No penalty
This structure provides more flexibility in Years 4 and 5, with only 2% and 1% penalties respectively. However, not all lenders offer this option—some cap the decline at 3%.
Shorter Prepayment Terms
Both fixed and declining structures can be offered with shorter terms. Common variations include:
- 3-year term: Penalty applies for Years 1-3 only. With a declining structure, this might look like 5%/4%/3%
- 4-year term: Penalty applies for Years 1-4. Declining structure: 5%/4%/3%/3%
- 1-year or 2-year terms: Less common, but some lenders offer these for borrowers with shorter hold targets
Trade-off: Shorter prepayment terms typically come with higher interest rates—often 0.25% to 0.50% higher than the 5-year option.
Prepayment Structure Comparison
Here’s how the structures compare on a $400,000 loan:
| Structure | Year 1 | Year 3 | Year 5 | Penalty-Free | Total Cost |
| 5% Fixed (5-yr) | $20,000 | $20,000 | $20,000 | Year 6 | Flat |
| 5-4-3-3-3 (3% floor) | $20,000 | $12,000 | $12,000 | Year 6 | Declines |
| 5-4-3-2-1 | $20,000 | $12,000 | $4,000 | Year 6 | Declines |
| 5-4-3 (3-yr term) | $20,000 | $12,000 | $0 | Year 4 | Shorter |
Note: The 5-4-3-2-1 structure is not available from all lenders. Some use a 3% floor on declining structures. Always confirm the specific structure with your lender.
How to Calculate Your Prepayment Penalty
The calculation is straightforward, but there’s one detail that often surprises borrowers: the penalty is based on the outstanding balance at the time of prepayment, not the original loan amount.
Step-by-Step Calculation
- Step 1: Determine the penalty percentage based on when you’re exiting and your structure
- Step 2: Get your current loan balance (from your statement or lender)
- Step 3: Multiply: Outstanding Balance × Penalty Percentage = Prepayment Penalty
Example Calculation
Let’s say you took out a $500,000 DSCR loan with a 5-year term and 5-4-3-3-3 declining structure. After 2 years and 6 months, you receive an offer to sell the property that you want to accept.
- Time period: Year 3 (penalty is 3%)
- Outstanding balance: $487,000 (after 2.5 years of payments)
- Prepayment penalty: $487,000 × 3% = $14,610
This $14,610 comes directly out of your sale proceeds, reducing your net profit from the deal. Use our DSCR calculator to model different scenarios and see how prepayment penalties affect your returns.
With a 5% fixed structure: The same exit in Year 3 would cost $487,000 × 5% = $24,350—nearly $10,000 more. This illustrates why the declining structure can be valuable if you anticipate selling in the middle years.
Choosing the Right Prepayment Structure
Match your prepayment structure to your investment strategy:
Long-Term Buy-and-Hold (6+ Years)
Recommended: 5% Fixed (5-year term)
If you’re building a portfolio for cash flow and long-term appreciation, take the lowest rate available. The prepayment penalty becomes irrelevant because you won’t trigger it. The 5% fixed structure typically offers the best rates. See our top DSCR markets for 2026 for markets that favor long-term holds.
Medium-Term Hold (3–5 Years)
Recommended: Declining structure (5-4-3-3-3 or 5-4-3-2-1 if available)
A declining structure gives you meaningful savings if you exit in Years 3-5. Even with a 3% floor, you’re paying 40% less than the 5% fixed option in those years.
Shorter Hold or Value-Add (1–3 Years)
Recommended: Shorter prepayment term (3-year) or consider bridge financing
If your strategy involves stabilizing a property and then selling or refinancing within a few years, ask about shorter prepayment terms. A 3-year term lets you exit penalty-free by Year 4. Check our best fix-and-flip markets for 2026 if you’re considering value-add strategies.
For very short holds (under 18 months), a DSCR loan with any prepayment penalty may not be the right product. Consider a fix-and-flip loan or bridge loan instead—these typically have no prepayment penalties.
Rate Environment Considerations
The current rate environment should also influence your decision. See our DSCR loan rate environment guide for the latest trends.
- If rates are high and expected to fall: Consider shorter prepayment terms—you may want to refinance when rates drop
- If rates are low and stable: Lock in a longer term to get the best rate—you probably won’t want to refinance anyway
- If uncertain: The declining structure offers a middle ground—you get rate benefit but reduced penalties if you need to exit early
State Restrictions on Prepayment Penalties
Not all states allow prepayment penalties on investment property loans, and some have specific conditions:
States Where Prepayment Penalties Are Not Allowed
- Alaska
- Kansas
- Minnesota
- New Mexico
- Rhode Island
Note: Some of these restrictions may not apply to larger multifamily properties (5-10 units).
States with Conditional Restrictions
- Illinois: Prepayment penalties not allowed on loans to individuals with rates at or above 8%
- Mississippi: Only declining structures allowed (no fixed percentage)
- New Jersey: Prepayment penalties only allowed when the borrower is an entity (LLC, corporation)
- Pennsylvania: Not allowed on loan balances below a threshold set by the Dept of Banking & Securities ($319,777 for 2025) for 1-2 unit properties
- Ohio: Allowed on 3-4 unit SFR without restriction; for 1-2 units and condos, only allowed above certain loan amounts with penalties capped at 1%
What Doesn’t Trigger a Prepayment Penalty
Not every early payoff situation triggers the penalty. Common exceptions include:
- Partial prepayments below threshold: Most loans allow up to 20% annual prepayment of the original principal without penalty
- Insurance or condemnation proceeds: Payoffs from casualty insurance or eminent domain are often exempt
- End of term: Once you’re past the prepayment period, no penalty applies regardless of reason for payoff
Always check your loan documents: The specific exceptions and thresholds are defined in your promissory note and prepayment addendum.
Prepayment Penalties: DSCR vs. Bridge/Fix-and-Flip Loans
An important distinction: prepayment penalties are a feature of long-term DSCR loans, not short-term investment loans.
Bridge loans and fix-and-flip loans (typically 12–24 month terms) generally have no prepayment penalties. The business model assumes early payoff—that’s how these loans work. If a lender charges significant prepayment penalties on a 12-month bridge loan, that’s a red flag.
DSCR loans are designed for long-term rental property financing (5–30 year terms). Prepayment penalties protect the lender’s expected return over that longer period. If you’re new to DSCR financing, see our how to apply for a DSCR loan guide.
If you’re buying a property to renovate and sell quickly, a DSCR loan with a prepayment penalty is probably the wrong product. Match your financing to your strategy. For ground-up projects, consider our new construction loans.
American Heritage Lending’s Prepayment Options
At American Heritage Lending, our Invest Star DSCR program offers two prepayment structures designed for real estate investors:
5% Fixed Percentage
A flat 5% penalty applies for the duration of your chosen prepayment term (1-5 years). This structure typically comes with our most competitive rates, making it ideal for long-term investors who don’t anticipate selling or refinancing within the prepayment period.
Declining Structure (5%/4%/3% Floor)
Our declining structure starts at 5% in Year 1 and steps down each year, with a floor of 3%. For a 5-year term, this looks like:
- Year 1: 5%
- Year 2: 4%
- Year 3: 3%
- Year 4: 3%
- Year 5: 3%
This structure gives you meaningful savings if circumstances require an exit in Years 3-5, while still offering competitive rates.
Prepayment Term Options
You can choose prepayment terms from 1 to 5 years. Shorter terms provide earlier flexibility but typically come with slightly higher rates. Our loan officers can help you compare scenarios and choose the structure that maximizes your returns based on your specific investment timeline. We also offer foreign national DSCR loans with the same prepayment options.
Not sure which prepayment structure fits your investment strategy? Talk to an AHL loan officer. We’ll walk through different scenarios and help you make an informed decision based on your hold period and exit strategy.