Everything You Need To Know About Prepayment Penalties

December 12th, 2018 | Purchasing a Home, Refinancing a Home

Although they are not nearly as common today, some mortgage loans do come with a prepayment penalty. Home loan borrowers should be aware of them before signing their names on the dotted line. Here’s what you need to know about prepayment penalties:

What is a prepayment penalty?

A prepayment penalty is a fee the borrower must pay if they pay off the mortgage loan faster than the agreed terms. They often only apply during the first three years of the loan. Some prepayment penalty clauses also stipulate that a borrower cannot pay off more than 20% of the loan balance each year.

When would I have to pay a prepayment penalty?

While you may initially think that theses penalties are only for those who get a windfall of cash and put it towards their mortgage, the majority of them are triggered by either the sale of the home or a refinancing of the loan. Both of these effectively pay off the original mortgage. There are technically two types of prepayment penalties: hard and soft. A soft penalty is required when you refinance your home loan and a hard penalty applies to either refinancing or selling the home. It is important to know if your mortgage includes either of these before you commit. It could change your plans in terms of how long you stay in your home or how much you buy down your initial interest rate.  It could also make it difficult to take advantage of interest rate savings a year or two down the road if rate drop significantly.

How much money do they require?

It is common for a prepayment penalty clause to require a payment of 80% of six-months of interest. For example, if you have a $300,000 mortgage loan at 5%, your initial interest payment would be around $1,250. Multiple that by 6 and take 80% of that and you would face a prepayment penalty of roughly $6000. Depending on your situation, that could be a tough amount to hand over either when you sell or refinance. It could potentially negate any refinancing savings and reduce the profit of any sale.

Why do they exist?

Mortgage lenders have to expend consider labor costs to originate a home loan. They plan to earn back that money and their profits through the interest payments that will be made over the years. If the home loan is cut short for any reason, those interest payments to them stop and they could lose money on their investments. Prepayment penalties are a way for lenders (or the investors who buy the loans on the secondary market) to protect their initial capital outlay and their promised income. 

The one bright spot for borrowers is that allowing a prepayment penalty clause in a loan often results in a slightly lower interest rate.

Prepayment penalties can be avoided in most cases today. FHA loans never include these penalties, in fact. If you choose to allow one in your mortgage, be sure you understand all the terms and conditions that apply.

For questions about this topic, contact us.