Prepayment protection on a carry-back note: lockout, yield maintenance, or leave it open?

The part I hadn't thought about is that the payoff can hurt you on the tax side even though the money showed up. That's the opposite of how I'd have assumed it works.

I've carried on land twice and both notes were open, no penalty, and I'd write them open again. Long holds are my whole approach, so I'll say the unpopular thing: if a buyer pays me off in year three at 8 percent, I got three years of 8 percent and my principal back, and I can go do something with it. The scenario people are afraid of is the one where they set the rate too low and then feel robbed when it gets refinanced away. Set the rate right and early payoff isn't an insult.

The lockout does one thing I care about, though. It makes the note more sellable, because a buyer of paper is pricing an income stream and open prepayment makes that stream uncertain. If I thought I might sell, I'd want the seasoning language in there.

Two separate questions are stacked here and they have different answers.

On enforceability: prepayment penalties on residential mortgage debt are restricted in ways that depend on the state and on how the loan is characterized under federal rules that turn on occupancy, the number of transactions you do, and whether the note is consumer credit. Seller carry-back is treated differently from institutional lending in some of those rules, and the exemptions have counts and conditions attached. That determination is legal work, and you need an attorney in the state where the property sits before you draft any prepayment clause on an owner-occupied deal. Commercial and vacant land paper sits in a different place, which is why @orchard's land notes and an owner-occupant note aren't the same drafting problem.

On economics, assuming you're clear to write a restriction: a lockout and a step-down penalty protect different things. A lockout protects the timing of your income and your installment reporting, which is what matters if the deferral is the reason you structured the sale this way. A step-down penalty protects the value of the income, and it's easier to get a buyer to sign. Buyers push back harder on lockouts because a lockout can strand them if they need to sell.

The assumption the whole choice rests on is whether you expect this note to be held to term or resold. Held to term, an open note at a rate you're happy with costs you little. Resold, prepayment language is part of what the note buyer is pricing, and open prepayment shows up as a discount. Confirm the current tax treatment of an accelerated payoff under installment reporting with your CPA in writing, because that consequence lands in the year of payoff, not the year you drafted.

Rural low price point paper, and I'll add the case nobody's raised. A partial prepayment clause matters more than the total payoff one out of here. Buyers with $40k notes send an extra $2,000 after a good year and want it applied to principal, and if the note doesn't say how extra payments are applied, you get an argument three years later about the balance. My last one said additional payments apply to principal and do not change the payment amount or due dates, and that sentence has saved me two phone calls already.