Prepayment Penalty: What It Is And How To Avoid It
For many homeowners, the concept of a “prepayment penalty” seems strange. Why should early loan repayment result in a penalty?
That’s the issue with mortgage loans: many of them have unexpected prepayment penalties, which limit your choices and can be costly. There’s a valid reason why lenders may not want you to pay off your mortgage early, which we’ll get to soon.
When comparing house loans and selecting which sort of mortgage is best for you, keep an eye out for prepayment penalties. By understanding the penalties now, you will be better prepared to approach your mortgage search and eventual contract.
It is crucial to know that Commercial Lending USA does not impose any prepayment penalties.
What is a prepayment penalty?
Some lenders charge a mortgage prepayment penalty if you pay off all or part of your mortgage loan early. The penalty fee encourages consumers to repay their principal slowly over time, allowing mortgage lenders to receive interest.
It is important to note that prepayment penalties do not often apply when you make a few extra payments to pay off your principle faster or make principal-only payments. Most mortgage lenders enable borrowers to pay off up to 20% of their loan balance annually. Instead, when refinancing, selling, or paying off substantial sums of a loan at once, a mortgage prepayment penalty often applies.
Types of Prepayment Penalties
It’s crucial to understand that there are two types of prepayment penalties:
- A mild prepayment penalty allows you to sell your house without incurring a penalty, so it would apply if you refinanced or just paid down a large portion of the loan during the early years.
- A harsh prepayment penalty would apply in the conditions described above, as well as if you sold the home.
Why do lenders charge a mortgage prepayment penalty?
A mortgage contract includes repayment penalties to protect the lender from losing interest payments over the loan’s duration. Let’s get to the specifics.
The first few years of a loan are more risky for the lender than for the borrower. Most borrowers haven’t put down a considerable amount of money in relation to the value of the home. That is why lenders charge mortgage interest to protect against financial loss.
If a borrower repays the loan right away, the lender loses all of the interest costs that were included in the loan as an incentive to provide the borrower with a loan.
Mortgage lenders use the mortgage penalty to offer lower interest rates, knowing that they will make up the difference through interest payments over the course of the loan. If you pay off your mortgage before the lender has recouped their costs, they will get money from the prepayment penalty.
How Much Is the Prepayment Penalty?
- As one might assume, prepayment penalty fees differ. However, there are certain common approaches for calculating penalty costs.
- Percentage of remaining loan balance: The lender will impose a penalty fee of 2% of the outstanding principle if you pay off the loan within the first two or three years of the loan term.
- X number of months’ interest: The borrower will pay interest for a set number of months, such as six.
- With this arrangement, the lender enters a fixed amount, such as $3,000, for repaying a loan during the first year. This isn’t commonly used in mortgages.
- Sliding scale for mortgage length: This is the most popular model. Consider a sequential 2/1 prepayment penalty over the first two years of the loan as an example. If you pay off the mortgage in year one, the penalty amounts to 2% of the remaining principal balance. Should you pay off the mortgage in year two, the penalty drops to 1% of the remaining principal balance.
Prepayment Penalty Example:
Looking to have some fun with math? We break down those costs using a common mortgage principle and interest rate model. Let us consider a $200,000 loan.
- If the loan is paid in full within the first two years of the note, the penalty is $3,600 if you had 10% equity prior to the payoff ($180,000 minus 2%, or 0.02).
- X amount of months of interest: If the loan is paid in full within the first two years of the note, the penalty is around $5,000. First, multiply the principal balance by the interest rate (assuming a 5% rate). Then divide that number by 12 to calculate the monthly interest payment. Finally, multiply the number by 6 to get the cost of 6 months’ interest. The equation should appear like this:
$200,000 ✕.05 = $10,000
$10,000 divided by 12 months equals $833.33.
The penalty amount is approximately $5,000, calculated as $833.33 multiplied by 6 months.
Fixed amount: You would pay whatever the indicated fixed sum is, say $3,000.
Sliding scale for mortgage length: On a $200,000 loan, the mortgage penalty is $4,000 if paid off in year one and $2,000 if paid off in year two.
Interpreting Your Mortgage Contract
As with any financial agreement, you should read the fine print. In this instance, you’ll want to know if your mortgage contract includes a prepayment penalty clause and how to understand the repercussions of triggering it.
Check for a loan prepayment clause.
The law mandates lenders to disclose prepayment penalties as well as monthly payments, fees, and other loan information. As previously stated, you should study the “fine print”—in t this case, the loan estimate or the papers that you will sign at closing—which will be prominently listed in the addenda and/or disclosure documents among the other terms of your mortgage loan.
Asking your lender if they impose a prepayment penalty is completely acceptable; if they do, ask them to show you where the specifics are located in the documentation. If you already have a loan, check your monthly billing statement for details.
Certain cases prohibit prepayment penalties. This includes:
FHA loans
Department of Veterans Affairs (VA) loans
US Department of Agriculture (USDA) loans
Student loans (While these loans are not mortgages, it’s still useful information to know.)
Learn what will and will not trigger the prepayment fee.
As previously stated, making a few extra payments will not result in the prepayment penalty fee kicking in. However, you should be mindful of other instances when they occur.
Penalties often cover the initial few years of a loan, which are the most risky for the lender. If you refinance in the early phases of your loan term, you will incur a prepayment penalty. Your mortgage contract’s penalty fee type will determine the amount of the fee. Consider the above models as an example of what that could be.
As you read through your loan estimate and contract, keep an eye out for the type of prepayment penalty that comes with your loan, just in case you decide to refinance or sell. If you’re unclear, contact your mortgage lender before signing the paperwork and ask them to guide you through the calculations for your type of prepayment penalty, loan amount, amortization, and interest rate.
What to do with a prepayment clause.
Does the prospect of another fee give you pause? Before signing your mortgage deal, consider the following:
Understand the potential costs.
Even if you don’t expect to face the prepayment penalty, it’s a good idea to be aware of the consequences in case you do. In reality, it could mean the difference between selecting a loan with a prepayment penalty and one without.
Determine the sort of prepayment penalty associated with your mortgage and compare the cost of remaining on your existing loan after the penalty date against the cost of paying it off early and incurring the penalty. Each homebuyer must decide which option is best for their specific financial condition.
Negotiate to remove the prepayment clause.
If you decide to stay with your lender and the mortgage despite the penalty, you might try to negotiate a lesser cost. After all, even if you intend to live in your new house for many years, it may be worthwhile to attempt bargaining to reduce your risks in case something changes.
You can always try to negotiate its removal from the contract; ask your lender if they will forgo the cost. If they agree, make sure to get it in writing. You can also request a penalty-free quote from your lender, but keep in mind that this may result in an increase in the interest rate.
Finally, look for mortgage lenders that do not charge mortgage prepayment penalties, as this is one less thing to worry about in the long run.
Determine if you need to worry about a prepayment penalty.
While anything can happen, and you can never be certain that you will not sell or refinance your home, the following questions can help you determine the risk of a prepayment penalty:
Are you intending to sell or refinance your property soon?
If you know you’ll be in one spot for an extended period of time (as far as anyone can be certain, of course), the penalty may never apply to you.
If you currently have a low mortgage interest rate, you are unlikely to refinance.
How crucial is it to be able to pay off your home loan early?
If you wish to pay off your mortgage early, look into mortgage lenders who do not charge a prepayment penalty. You may also decide to refinance your mortgage in the future to consolidate debt. Keep in mind that doing so will result in you missing out on the mortgage interest deduction (for the percentage of your balance added to the refinance).
How to Avoid the Prepayment Penalty
Remember that there are other options besides incurring a prepayment penalty. One alternative is to try to negotiate a lesser cost, but the easiest approach to avoid the penalty entirely is to change loan types or lenders.
Because not all lenders have the same prepayment penalty, browse around and compare lenders to get the best mortgage choice for you. You can also look for lenders who do not impose prepayment penalties, such as Commercial Lending USA.
Prepayment Penalty FAQs
Below, we address some more questions you may have about mortgage prepayment penalties.
How does prepaying a mortgage loan affect my credit score?
While canceling a credit card can affect your credit score, prepaying your mortgage should have no effect on your total score. When considering whether to pay off your mortgage early, your credit score is usually unimportant.
How can I find out whether my mortgage includes a penalty for paying it off early?
The best option is to contact your lender or potential lender. Law requires them to reveal these terms to borrowers. Ask your lender to point out the contract’s fine print on prepayment penalties. It should be prominently displayed in your loan estimate and closing disclosure.
Is it worth paying off my mortgage early?
You’ll need to analyze the math on your mortgage terms to see if it’s worthwhile to pay it off early. The further along you are with your mortgage, the more probable it will work out for you. Previously, your greatest long-term plan may have been to make extra payments on occasion.
The bottom line
Check to see if the mortgage deal includes a prepayment penalty. You should also look for lenders like Commercial Lending USA that do not charge prepayment penalties.
