Prepayment language on a seller-financed note: protect the yield or keep the paper liquid

A prepayment clause that simply allows the borrower to prepay in whole or in part at any time without penalty hands the duration of the asset to the borrower. If they refinance in month 14, the lender gets principal back and a coupon that can't be replaced at the same yield, having already absorbed the setup cost for what turned out to be a year of payments. Two structures come up most often. A step-down penalty, say 2 percent in year one, 1 percent in year two, open after, protects the yield and makes cash flow more predictable. The cost shows up at the negotiating table, because a buyer whose entire plan is to season twelve months and refinance into a conventional loan will push back hard on that clause, or walk from the deal entirely. Open prepay, priced with a somewhat higher coupon as compensation, keeps the borrower comfortable and the document simple, which is often what note buyers say they want to see when they bid on paper. How far a prepayment charge is enforceable on owner-carried residential paper depends on state law and on the characteristics of the loan, so that clause belongs with a lawyer licensed where the property sits, not a generic template. There isn't a single settled answer here. On paper intended to be held long term, the penalty tends to be worth the friction. On paper likely to be sold within a couple of years, it may not earn its keep at bid time, since buyers often discount notes with prepayment penalties they view as friction rather than protection.