DSCR 5-4-3-2-1 Prepayment Penalty Explained: What Each Year Costs

If you have looked at a DSCR loan quote lately, you may have seen five numbers in a row next to the words "prepayment penalty": 5-4-3-2-1. It looks like a countdown, and in a way it is. It tells you what it would cost to pay the loan off early in each of the first five years, and when that cost finally reaches zero.

Plenty of experienced investors sign this term without running the numbers on it. That is no failing on their part. The schedule is written as percentages, the real cost lives in dollars, and the dollars depend on a date you probably have not picked yet: the day you sell or refinance.

This guide explains how a 5-4-3-2-1 prepayment penalty works on a DSCR loan, what it costs in each year, why investor loans can carry it at all, and how to decide whether it fits your plan for the property.

What a 5-4-3-2-1 prepayment penalty means

A prepayment penalty is a fee some lenders charge if you pay off all or part of your mortgage early, usually because you sold the property or refinanced it. A 5-4-3-2-1 schedule is a step-down version of that fee. The percentage drops by one point each year until it disappears.

Here is how it usually reads on a DSCR loan:

• Pay off the loan in year one, and the penalty is 5 percent of the amount prepaid
• In year two, it is 4 percent
• In year three, 3 percent
• In year four, 2 percent
• In year five, 1 percent
• From the start of year six, there is no penalty

The "years" are counted from the loan's closing or first payment date, depending on how the note is written. They are not calendar years. A loan that closes in October has its first anniversary the following October, and that is when the percentage steps down.

What it costs in dollars, year by year

Percentages are abstract, so put the schedule in dollars. Take a $300,000 DSCR loan on a single rental and assume you pay it off in full. To keep the math clean, use the original balance. Your real balance will be a bit lower each year as you pay down principal, so actual penalties come in slightly under these figures.

Two things stand out. First, an early exit is expensive: $15,000 in year one is real money, often more than a year of the property's cash flow. Second, each anniversary is worth $3,000 on this loan. Selling in month 36 instead of month 37 costs about $3,000 more for the same property and the same buyer, just because of the date on the closing.

That second point is one of the most useful things to know about a 5-4-3-2-1 schedule. If you are near an anniversary and have some control over timing, a few weeks can make a measurable difference.

Why DSCR loans can carry a penalty this long

If you have an owner-occupied mortgage, you may never have seen a five-year penalty. There is a reason for that.

For consumer mortgages, federal rules sharply limit prepayment penalties. Under Regulation Z, a penalty is generally allowed only on a fixed-rate qualified mortgage that is not a higher-priced loan. Even then it cannot exceed 2 percent in the first two years or 1 percent in the third year, and none is allowed after three years. A lender that offers a consumer a loan with a penalty must also offer an alternative without one.

A DSCR loan sits outside those rules. Credit used to buy, improve, or maintain a rental property you do not live in is deemed to be for business purposes, regardless of the number of units, and business-purpose credit is exempt from Regulation Z. That exemption is what lets a DSCR loan qualify the property on its rent instead of your tax return. It is also what allows longer, steeper penalty schedules like 5-4-3-2-1.

Why would a lender want one? Investor loans are often priced on the expectation that the interest will keep coming for a while. A penalty protects that expectation if the borrower leaves early. In exchange, a loan with a longer penalty is often priced more favorably than the same loan with a shorter one or none at all. That trade is the whole decision.

How 5-4-3-2-1 compares with other schedules

A 5-4-3-2-1 step-down is one of several structures you may be offered. The common ones look like this:

• A 3-2-1 step-down runs three years: 3 percent, then 2, then 1, then nothing
• A five-year flat penalty charges the same percentage, such as 5 percent, for all five years
• A shorter flat or "hard" penalty might charge 3 percent for three years and then drop to zero
• Yield maintenance charges an amount designed to make the lender whole for the interest it would have earned, which can be large when market conditions shift

Compared with a five-year flat penalty, 5-4-3-2-1 is gentler, because the cost falls every year. Compared with a 3-2-1, it is longer and steeper, so it usually comes with better pricing. We cover each structure in more depth in DSCR refinance and prepayment penalties.

How to decide whether 5-4-3-2-1 fits your plan

The right penalty depends on one question: how long will you realistically hold this loan? That is a different question from how long you plan to own the property. A refinance ends the loan too.

Start with your honest hold period

Write down the reasons you might pay this loan off early. Common ones include:

• Selling the property, whether planned or because life changes
• A cash-out refinance to pull equity for the next purchase
• Refinancing if your situation or the market shifts in your favor
• Moving the property into or out of an LLC in a way that requires a new loan
• Consolidating several rentals into one portfolio loan

If none of those are likely in the next five years, a 5-4-3-2-1 penalty may never cost you anything, and the better pricing it buys is a straightforward gain. If one of them is likely in years one through three, the penalty deserves careful math.

Run the break-even with your own numbers

Ask for two versions of the same loan: one with the 5-4-3-2-1 penalty and one with a shorter penalty or none. Then compare the difference in monthly payment and upfront cost against the penalty you would owe at your likely exit.

Here is an example with made-up numbers. Say the no-penalty version of your loan costs $150 a month more than the 5-4-3-2-1 version, with the same closing costs.

• If you exit at month 30 (year three), the no-penalty loan costs you $150 x 30 = $4,500 extra in payments. The 5-4-3-2-1 loan would charge about $9,000 at payoff. The no-penalty loan wins by about $4,500.
• If you exit at month 60 (year five), the no-penalty loan costs $150 x 60 = $9,000 extra. The 5-4-3-2-1 loan charges about $3,000. The penalty loan wins by about $6,000.
• If you hold past year five, the penalty never applies and the 5-4-3-2-1 version wins by $150 for every month you keep it.

Your numbers will differ, but the method holds. Find the month where the two lines cross. If your realistic exit is before it, a shorter penalty is likely the better buy. If your exit is after it, 5-4-3-2-1 is likely the better buy.

Look past the headline rate

A loan with a long penalty can look cheaper on the quote because the rate is lower. That rate is only part of the cost. The full picture includes the payment, the fees, the reserves the loan requires, and the penalty you would pay at your most likely exit. A lower rate with a $9,000 exit cost can be the more expensive loan for someone who sells in year three. Our guide to comparing DSCR loan quotes walks through that side-by-side.

Questions to ask before you sign

The schedule on the term sheet is only a summary. The note controls. Before closing, ask for answers in writing to these questions:

1. Is the penalty calculated on the full outstanding balance or only on the amount prepaid?
2. Are partial prepayments allowed without a penalty, and if so, how much per year?
3. Does the penalty apply when you sell the property, or only when you refinance?
4. Does it apply if you refinance with the same lender?
5. Are the penalty years measured from the closing date or the first payment date?
6. What does the same loan cost with a 3-2-1 schedule, or with no penalty at all?
7. Does any state law where the property sits change how the penalty can be written?

On a consumer mortgage, the Loan Estimate shows whether a loan has a prepayment penalty. Because a DSCR loan is business-purpose credit, you may not receive that standard form, so get the penalty terms on the term sheet and confirm them against the note before you sign. Our breakdown of DSCR Loan Estimate fees covers the rest of the cost sheet.

A note on taxes

For a personal residence, IRS guidance says a mortgage prepayment penalty can be deducted as home mortgage interest, as long as it is not a charge for a specific service. Rental property follows its own rules in Publication 527, and how a penalty is treated can depend on whether you sold the property or refinanced it. Ask your tax preparer before you count on any deduction. It can change the real cost of an early exit, but it should not drive the decision on its own.

When a 5-4-3-2-1 penalty usually makes sense

A 5-4-3-2-1 schedule tends to fit investors who:

• Buy rentals to hold for the long run, not to flip or reposition quickly
• Have already done the renovation and refinance work on the property
• Want the most favorable pricing and are confident they will keep the loan past year five
• Have reserves set aside, so a surprise expense does not force a sale

It tends to fit poorly when you plan a cash-out refinance within a couple of years, when the property is a value-add project still in progress, or when your plans for the property are honestly uncertain. In those cases, paying a little more for a shorter penalty buys flexibility. And sometimes the honest answer is that a DSCR loan is not the right tool for the deal at all.

Talk it through with a GoodLoan loan officer

A 5-4-3-2-1 prepayment penalty is a trade: better pricing now in exchange for a cost if you leave early. Whether that trade works depends on your timeline. A GoodLoan loan officer can lay out the same DSCR loan with different penalty schedules side by side, show you the total cost at the exit dates you care about, and tell you plainly which one fits. We are licensed through the NMLS, and we say no a lot, including to structures that do not fit your plan. The first conversation is a review of your numbers.

Frequently asked questions

What does 5-4-3-2-1 mean on a DSCR loan?

It is a step-down prepayment penalty. If you pay off the loan early, you owe 5 percent of the amount prepaid in year one, 4 percent in year two, 3 percent in year three, 2 percent in year four, and 1 percent in year five. From year six on, there is no penalty.

Does selling the property trigger the penalty?

Usually, yes. A sale pays off the loan, and most DSCR prepayment penalties apply to any early payoff, whether from a sale or a refinance. Check the note, since terms vary.

Can I make extra principal payments on a loan with a 5-4-3-2-1 penalty?

Some notes allow partial prepayments up to a set amount each year without a penalty, and others charge on any prepayment. Ask for the exact terms in writing before you close.

Why do owner-occupied mortgages rarely have penalties like this?

Federal rules for consumer mortgages cap prepayment penalties at 2 percent in the first two years and 1 percent in the third, with none after three years, and only on certain loans. DSCR loans are business-purpose credit, so those caps do not apply.

Is a 5-4-3-2-1 penalty worth it for better pricing?

It can be, if you are confident you will keep the loan past year five or near it. Compare the monthly savings against the penalty at your likely exit date. If you expect to sell or refinance within three years, a shorter penalty is often the better buy.

Can I negotiate a different penalty schedule?

Often you can choose among several schedules, such as 5-4-3-2-1, 3-2-1, or none, each priced differently. Ask to see the same loan quoted with each option so you can compare the total cost.