DSCR Loan Prepayment Penalties: Why Investors Choose Them

As a seasoned real estate investor in Colorado, you know that the best deals are made at the closing table. While DSCR loans offer incredible flexibility such as no personal income verification and closing in an LLC, they almost always come with a feature that conventional loans do not: a Prepayment Penalty (PPP).

A prepayment penalty is a fee charged if you pay off your loan early, either by selling the property or by refinancing with a different lender, within a specified initial period (typically the first three to five years).

While this sounds like a drawback, savvy investors strategically choose to include a prepayment penalty because it is a powerful lever to access a lower interest rate on the loan.

Why Investors Choose the Prepayment Penalty

DSCR loans are primarily funded by private capital and are often bundled into mortgage-backed securities. Investors who buy those securities rely on predictable interest income. When a loan is paid off early, the yield is lost, which is why the penalty exists, to protect the lender’s expected return.

In exchange for giving the lender this assurance of long-term interest income, you are rewarded with superior loan terms:

Factor	No Prepayment Penalty (No PPP)	With Prepayment Penalty (PPP)
Interest Rate	Higher (Lender takes more risk)	Lower (Lender’s risk is mitigated)
Upfront Fees (Points)	Often higher origination fees/points	Often lower origination fees/points
Investor Profile	Flippers, or those expecting a fast refinance	Buy-and-Hold Investors

For the long-term, cash-flow-focused investor in Colorado, accepting a prepayment penalty is often the smartest financial move, securing a lower payment for the full 30-year term in exchange for a risk they rarely intend to take.

Understanding the Three Common Penalty Structures

Prepayment penalties are most commonly structured as a step-down penalty, where the percentage fee on the remaining balance decreases each year.

1. The 5-4-3-2-1 Structure:
   • Penalty: 5% in Year 1, 4% in Year 2, 3% in Year 3, 2% in Year 4, 1% in Year 5.
   • Investor Profile: This is typically offered for the absolute lowest interest rate and is ideal for investors with a very long-term (10+ years) holding strategy who are extremely confident they will not sell or refinance within five years.
2. The 3-2-1 Structure:
   • Penalty: 3% in Year 1, 2% in Year 2, 1% in Year 3, then 0% thereafter.
   • Investor Profile: The most common choice. This offers a middle-ground rate reduction but provides flexibility to refinance or sell after the three-year mark, making it perfect for the BRRRR investor whose Cash-Out Refinance is planned for Year 4 or later.
3. No Penalty Option (0-0-0):
   • Penalty: $0 at all times.
   • Investor Profile: This is available but comes with the highest interest rate and/or highest upfront points/fees. It is only suitable for the investor who needs maximum flexibility or plans to exit the property within the first 12 months.

How to Strategically Avoid the Penalty Fee

If you are committed to a long-term hold, the penalty will never affect you. However, market forces or unexpected opportunities might require an early exit. Here is how sophisticated investors navigate the prepayment period:

1. Time Your Exit: If you are nearing the end of your penalty period (e.g., you are in Month 34 of a 3-year penalty), it is almost always worth waiting a few extra months to hit the penalty-free window.
2. Refinance Strategically: Prepayment penalties may hurt if rates decrease. However, even if you pay a 2% penalty on a $300,000 loan ($6,000), the potential long-term savings from a lower rate or the cash-out equity from appreciation often make the refinancing decision economically beneficial overall. Do the math before you proceed!
3. Partial Prepayments: DSCR loan terms often restrict partial prepayments of principal during the penalty period. For example, if you have a 3-2-1 penalty, making an extra $10,000 principal payment in Year 1 may trigger a 3% fee on that $10,000 (a $300 penalty). Always check your loan documents to understand your allowance for extra principal payments.

For detailed information on the securitization process that drives these penalty requirements, review guidance from the Securities and Exchange Commission (SEC) on mortgage-backed securities. [Authority Link 1]

General guidelines on commercial real estate financing, including penalty structures, can be found through the Commercial Real Estate Finance Council.

Finally, a strong understanding of your potential tax implications upon the sale of a property can be further researched using guides from the IRS, which is critical when deciding if the penalty is worth the sale.

Don’t Let the Penalty Scare You

The prepayment penalty is a trade-off: in exchange for a commitment, you receive a lower cost of capital, which instantly improves your cash flow and increases your return on investment. The key is structuring the penalty to align perfectly with your investment timeline.

Let Choice Mortgage Group help you analyze your holding period and choose the penalty structure that maximizes your profitability and minimizes your risk.

Call Choice Mortgage Group at (303) 670-0137 or email rbaxter@choicemortgage.com to select the right DSCR prepayment structure for your portfolio.

For more articles on real estate investing and advanced mortgage strategies, visit our blog page.