Prepayment Penalty: What It Is And How To Avoid It
November 17, 2023 8-Minute Read
Author: Victoria Araj
For many homeowners, the concept of a “prepayment penalty” is odd. Why should you be penalized for paying a loan early?
Well, that’s the thing about mortgage loans: Many of them surprisingly come with prepayment penalties, which limit your flexibility and can take a bite out of your wallet. There’s a good reason why lenders might not want you to pay the mortgage off early, and we’ll get to that soon.
When you’re looking at home loans and deciding what type of mortgage is best for you, you should watch for prepayment penalties. By learning about penalties now, you can approach your mortgage search and eventual contract armed with more knowledge and strategies for finding the best mortgage lender to fit your needs.
It’s important to note that Rocket Mortgage® does not have any prepayment penalties.
What Is A Prepayment Penalty?
A mortgage prepayment penalty is a fee that some lenders charge when you pay all or part of your mortgage loan off early. The penalty fee is an incentive for borrowers to pay back their principal slowly over a longer term, allowing mortgage lenders to collect interest.
Note that prepayment penalties don’t normally kick in when you make a few extra payments to pay your principal off sooner or make principal-only payments. Most mortgage lenders allow borrowers to pay off up to 20% of the loan balance each year. Instead, a mortgage prepayment penalty typically applies in situations such as refinancing, selling or otherwise paying off large amounts of a loan at a time.
Types Of Prepayment Penalties
It’s important to know that there are two different kinds of prepayment penalties:
- Soft prepayment penalty: A soft prepay penalty allows you to sell your home without invoking the penalty, so it would apply if you refinanced or just paid off a big chunk during the early years of the loan.
- Hard prepayment penalty: A hard prepay penalty would apply in the above circumstances, plus if you sold the home.
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Why Do Lenders Charge A Mortgage Prepayment Penalty?
Prepayment penalties are included in a mortgage contract to protect the lender against the loss of interest payments over the life of the loan. Let’s get into the specifics.
The first few years of a loan term are riskier for the lender than the borrower. Most borrowers haven’t put down a significant amount of money when compared to the value of the house. That’s why lenders charge mortgage interest, which is protection from a financial loss.
If a borrower pays the loan off right away, the lender loses out on all the interest fees which were included in the loan as an incentive to them to give the borrower a loan.
Mortgage lenders include the mortgage penalty as a way to market lower interest rates, knowing that they will make up the difference over the life of the loan through interest payments. Or, the lender will receive funds from the prepayment penalty should you pay off the mortgage before they have recouped their costs.
How Much Is A Prepayment Penalty?
As might be expected, prepayment penalty costs vary. However, there are some typical models for determining penalty cost.
- Percentage of remaining loan balance: The lender will assign a small percentage, such as 2%, of the outstanding principal as a penalty fee if the payoff is made within the first 2 or 3 years of the loan term.
- X number of months’ interest: The borrower will pay a total of a certain number of months in interest, such as 6 months.
- Fixed amount: With this model, the lender writes in a set figure, such as $3,000, for paying off a loan within the first year. This is not typically used in mortgages.
- Sliding scale based on mortgage length: This is the most common model. Let’s use a sequential 2/1 prepayment penalty over the first 2 years of the loan as an example. If the mortgage is paid off during year 1, the penalty is 2% of the outstanding principal balance. If the mortgage is paid off during year 2, then the penalty is 1% of the outstanding principal balance.
Prepayment Penalty Example
Want to have some fun with math? Here’s how those costs break down when we use a model of a typical mortgage principal and interest rate. Let’s consider a hypothetical $200,000 loan.
- Percentage of remaining balance: If the loan is paid in full during the first 2 years of the note, the penalty is $3,600 if you had 10% equity prior to the payoff ($180,000 ✕ 2%, or 0.02).
- X number of months’ interest: If the loan is paid in full during the first 2 years of the note, the penalty is about $5,000. First, multiply the principal balance by the interest rate (let’s say a 5% rate). Then, divide that number by 12 to get the amount of interest paid per month. Finally, multiply the number by 6 to get the fee of 6 months’ interest. The equation should look like this:
$200,000 ✕ .05 = $10,000
$10,000 ÷ 12 months = $833.33
$833.33 ✕ 6 months’ penalty amount = about a $5,000 penalty
- Fixed amount: You would pay whatever the stated fixed amount is, such as $3,000.
- Sliding scale based on mortgage length: On a $200,000 loan amount, the mortgage penalty would be $4,000 if paid off during year 1 of the note, with a $2,000 penalty if paid off during year 2 of the note.
Interpreting Your Mortgage Contract
As with any financial contract, you should read the fine print. In this case, you’ll want to find out if there is a prepayment penalty clause in your mortgage contract and how to interpret the consequences of triggering the fee.
Check For A Loan Prepayment Clause
The law requires lenders to disclose prepayment penalties, along with monthly payments, fees and other loan details. As mentioned, you’ll want to read the “fine print” – in this case, the Loan Estimate or the paperwork that you’ll sign at closing – where you’ll find it mentioned prominently in the addendums and/or disclosure documents with all the other terms of your mortgage loan.
It’s perfectly fine to ask your lender if they charge a prepayment penalty; if they do, ask them to show where in the paperwork you would find the details. If you already have a loan, you can look at your monthly billing statement, as it should be outlined in there.
There are some instances where prepayment penalties are illegal. These include:
- Federal Housing Administration (FHA) loans
- Department of Veterans Affairs (VA) loans
- United States Department of Agriculture (USDA) loans
- Student loans (It’s true that these loans aren’t mortgages, but it’s still good bonus info to know.)
Learn What Will And Won’t Trigger The Prepayment Fee
As we mentioned, making a few extra payments is not going to cause the prepayment penalty fee to kick in. But there are other times that you should be aware of when it will.
Penalties usually cover the first few years of a loan, because those are the riskiest for the lender. If you refinance in the early stages of your loan term, you’ll trigger the prepayment penalty. The amount of the fee will differ based on the type of penalty fee that’s included in your mortgage contract. See the above models for an example of what that could be.
As you’re reading through your Loan Estimate and contract, be aware of the type of prepayment penalty that comes with your loan, just in case something happens and you decide to refinance and/or sell. If you’re unsure, ask your mortgage lender before signing the paperwork and ask them to walk you through the math as it applies to your type of prepayment penalty, your loan amount, your amortization and your interest rate.
What To Do With A Prepayment Clause
Does the thought of one more fee give you pause? Here are some things to consider before signing your mortgage contract:
Understand The Potential Costs
Even if you don’t think you’re ever going to trigger the prepayment penalty, it’s a good idea to know the costs, just in case. In fact, it might make the difference between choosing a loan with a prepayment penalty and one without.
Find out the type of prepayment penalty that comes with your mortgage and compare the cost of staying in your current loan past the penalty date with the cost of paying it off early and invoking the penalty. Each home buyer must consider which route feels best for their personal financial situation.
Negotiate To Remove The Prepayment Clause
If you decide to stick with your lender and the mortgage with the penalty, you can try to negotiate a lower fee. After all, even if you plan on staying in your new home for many years, it may be worth it to try negotiating to mitigate your risks in case something changes.
You can always try to negotiate having it removed from the contract; ask your lender if they will waive the fee. If they agree, make sure you have it in writing. You can also ask your lender for a quote without the penalty, but remember, that might increase your interest rate.
And finally, you can look for mortgage lenders that don’t use mortgage prepayment penalties, since that’s one less thing to worry about over the long run.
Determine Whether You Need To Worry About A Prepayment Penalty
While anything can happen and you can never be 100% certain you won’t sell or refinance your house, these questions can help you determine the possibility of a potential prepayment penalty:
- Are you planning on selling or refinancing your home relatively soon?
- If you know you’re going to be in one place for a length of time (as far as anyone can be certain, of course), the penalty might not ever affect you.
- If you already have a low mortgage interest rate, you’re unlikely to be refinancing.
- How important is it to have the ability to pay off your home loan early?
- If you’re looking to pay off your mortgage early, you might want to consider mortgage lenders who don’t charge a prepayment penalty. You might also choose to refinance your mortgage in the future to consolidate debt. Keep in mind that you’ll miss out on the mortgage interest deduction (for the portion of your balance being added in the refinance) if you do so.
How To Avoid A Prepayment Penalty
Remember that there are other alternatives to accepting a prepayment penalty. One option is to try negotiating a lower fee, but the best way to avoid the penalty altogether is to switch to a different loan type or lender.
Since not all lenders charge the same prepayment penalty, make sure to shop around and compare lenders to find the best mortgage option for you. You can also look for lenders who don’t charge prepayment penalties, like Rocket Mortgage.
Prepayment Penalty FAQs
Below, we answer some additional questions you may have about mortgage prepayment penalties.
Does prepaying a mortgage loan affect my credit score?
Whereas something like closing a credit card can lower your credit score, prepaying your mortgage shouldn’t have a significant impact on your overall score. You typically won’t have to worry about your credit score if you’re deciding whether to pay off your mortgage early.
How do I find out if my mortgage has a penalty for paying it off early?
The best way is to ask your lender or potential lender. They’re required by law to disclose these terms to borrowers. Ask your lender to point out the fine print in the contract that covers prepayment penalties. It should also be prominently featured in your Loan Estimate and Closing Disclosure.
Is it worth paying off my mortgage early?
You’ll have to crunch the numbers on your mortgage terms to determine whether it’s worth paying off early. The further along you are in your mortgage, the more likely it is to work out for you. Earlier on, your best long-term strategy might be to make an extra payment now and then.
The Bottom Line
Before you choose a mortgage, verify whether the contract includes a prepayment penalty. You should also consider lenders like Rocket Mortgage that don’t charge prepayment penalties.
Ready to explore your mortgage options? You can start the approval process today.
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