Prepayment Penalty: What To Know And How To Avoid It

Paying off your mortgage early can save you a lot of money on interest, even if you’re refinancing your home or selling it. But it’s not the best news for lenders, which need the interest you pay to stay in business. That’s why some lenders charge borrowers who pay off their mortgage early a prepayment penalty. Understanding prepayment penalties allows you to determine if it’s worthwhile to refinance, sell your home or pay off your entire mortgage balance. Here’s what you need to know.

Key Takeaways:

What Is A Prepayment Penalty?

A mortgage prepayment penalty, also called an early payoff penalty, is a fee your lender may charge when you pay off a large part or all of your home loan early. These terms are agreed to when close on your mortgage.

Lenders may charge prepayment penalties only on home loans repaid in full within three years of closing. This includes loans repaid because the owner is refinancing their mortgage or selling their home.

Such penalties apply only when you repay all or a significant portion of the loan. Lenders typically allow borrowers to pay up to 20% of their loan balance each year without penalty. You usually won’t be penalized for making a few extra loan payments here and there to chip away at your principal.

Look at your mortgage documents to verify the details and see if you have a prepayment penalty. Some mortgages don’t contain a prepayment penalty clause.

There are typically two types of prepayment penalties:

Why Do Lenders Charge A Prepayment Penalty?

Lenders make money by charging interest, and an early payoff means they forego tens of thousands of dollars of potential interest over the years – if not more. The early part of the loan term poses the most financial danger to lenders because they’ve had no chance to collect enough interest to make money on the loan.

An early sale or refinance of a house is a loss of opportunity for the lender. Since the lender recently sunk resources into providing the mortgage, they’re looking for a return on their investment for years to come, not simply to be repaid the exact loan balance they just lent out.

So, if you’re currently shopping for a mortgage, note the different interest rates and prepayment penalty fees among lenders to pick the option that suits you best.

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Understanding Your Prepayment Penalty Clause

Now that you understand the basic idea of a prepayment penalty let’s get into how this clause works and what you should be aware of.

Do Your Research

If you’re shopping for a mortgage and you’re concerned about a prepayment clause, here’s what you need to keep in mind:

Common Loans With A Prepayment Penalty Clause

The following loan types can come with a prepayment penalty clause:

Loans With No Prepayment Penalty Clause

It’s illegal for lenders to include prepayment penalty clauses with the following types of loans:

How Much Are Prepayment Penalties?

Prepayment fees vary by lender. The law requires your lender to provide your mortgage terms before closing.  Usually, the prepayment penalty will come in one of the following forms:

Remember that mortgage prepayment penalty stipulations are lenient up to a point. Most mortgage lenders will let you pay up to 20% of your mortgage balance each year without penalty.

How To Calculate A Prepayment Penalty

Let’s look at a couple of examples using a loan of $250,000 and an interest rate of 5%.

An interest-based mortgage prepayment penalty could be charged if the loan is paid off within the first three years of the term. Say your lender charged you six months of interest as a penalty. They would first calculate how much total interest you would’ve been paying each year:

$250,000 x 0.05 = $12,500

Then, they’d divide that amount to find how much interest you’d pay each month.:

$12,500/12 months = $1,041.67

Finally, they’d multiply your monthly rate by six to determine how much interest the lender would have collected over six months, and thus the amount they might choose to penalize you in this situation:

$1,041.67 x 6 months = a prepayment penalty fee of $6,250

To illustrate another type of prepayment penalty, a sliding scale fee based on the years remaining on your loan would be 2% of $250,000 if you paid off your mortgage in year one or two. That fee would come out to $5,000.

If your outstanding balance was $250,000 in year three, on the other hand, and you chose to pay off the mortgage in its entirety, the lender would likely charge a fee of only 1%, which would come out to $2,500.

Why would a borrower incur the prepayment penalty in any of these scenarios? Imagine you’re just two years into a 30-year mortgage, and you negotiate better terms with a different lender. If interest rates have fallen and you can refinance into a shorter mortgage with a lower interest rate, it could save you tens of thousands of dollars in interest over the life of the loan, even with the prepayment penalty.

How To Avoid A Mortgage Prepayment Penalty

Now that you know what a prepayment penalty is, how can you avoid it? The simplest way to handle it is to find a lender who doesn’t charge a penalty. When considering lenders, ask them about their policy regarding prepayment penalties. What percentage of the loan or interest does the penalty amount to? What would incur the prepayment penalty – selling the house or just choosing to refinance?

It’s worth noting that certain states don’t allow lenders to charge prepayment penalties. However, even in these states, banks may be regulated by federal instead of state law, so be sure to always ask about the policies and do your research.

Keep in mind that borrowers can try to negotiate with their lender to remove a prepayment penalty clause – or search for a lender that doesn’t charge this fee. You also can ask your lender to quote you a comparable loan without a prepayment penalty so you can compare your options.

FAQ

Here are answers to some frequently asked questions about prepayment penalties.

The Bottom Line

While a prepayment penalty may limit your options as a homeowner, it’s crucial to understand the terms of your mortgage. If the sale or refinance of your home is advantageous, paying the prepayment penalty cost can make sense if your calculations show you coming out ahead eventually. If your prepayment penalty clause expires soon, you might want to wait it out and avoid the fee altogether.

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Rory Arnold contributed to the reporting of this article.