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Prepayment Penalty: What It Is And How To Avoid It

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The phrase “prepayment penalty” is likely making you curious. After all, why would you be penalized for prepaying something, which almost always is a benefit to the entity being paid? Well, that’s the thing about mortgage loans: Many of them surprisingly come with prepayment penalties, which limits your flexibility and can take a bite out of your wallet – just for trying to do the right thing for your finances.

So when you’re looking at home loans and trying to decide what is the best type of mortgage for you, this is a feature you should be aware of, as prepayment penalties are sometimes hidden in mortgage contracts. By learning about penalties now, you can approach your mortgage search and eventual contract with more knowledge, armed with 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 term off early. The penalty fee is an incentive for borrowers to pay back their principal slowly over a full term, allowing mortgage lenders to collect interest.

Note that it doesn’t normally kick in when you make a few extra payments here and there in an effort to pay your principal off sooner; 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.

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Why Do Lenders Charge Prepayment Penalties?

Typically most people from whom you borrow money want it back as soon as possible. But here is why mortgage lenders don’t.

The first few years of a loan term are riskier for the lender than the borrower. That’s because most borrowers haven’t put down a significant amount of money when compared to the value of the house. That’s why lenders charge you “interest,” which is protection from a financial loss. If you pay the loan off right away, they lose out on all those interest fees which were included in the loan as an incentive to them to give you, the borrower, a loan.

That’s why many lenders include the mortgage penalty in the first place – they offer it as a way to market lower interest rates, knowing that they will make up the difference over the life of the loan, or in receiving a prepayment penalty should you pay off the mortgage before they have recouped their costs.

How Much Will I Pay?

As might be expected, prepayment penalty costs vary. However, there are some typical models for determining penalty cost:

  • Percentage of remaining loan balance: Here they 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: Here you just pay a total of a certain number of months interest, such as 6 months.
  • Fixed amount: With this, 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; an example is a sequential 2/1 prepayment penalty over the first 2 years of the loan. If the mortgage is paid off during year 1, the penalty is 2% of the outstanding principal balance, and if the mortgage is paid off during year 2, then the penalty is 1% of the outstanding principal balance.

Want to have some fun with math? Here’s how it looks when we use a model of a typical mortgage and interest rateWe used a hypothetical $200,000 loan.

  • Percentage of remaining balance: If the loan paid is paid in full during the first 2 years of the note, the penalty is $4,000. ($200,000 x 2%).
  • X number of months’ interest: If the loan is paid in full during the first 2 years of the note, the penalty is $5,000. ($200,000 x .05= $10,000/12 months = 833.33 x 6 months penalty amount = $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 clause in your mortgage contract and how to interpret the consequences of triggering the fee.

How Do I Check For A Prepayment Clause?

The good news is that the law requires lenders to disclose prepayment penalties, along with monthly 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 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:

  • FHA loans
  • VA loans
  • USDA loans
  • Student loans or personal loans (yes, we know these aren’t mortgages, but still, good to know).

Learn What Will And Won’t Trigger The Fee

So 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.

First it’s important to know that there are two different kinds of prepayment penalties:

  • 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.
  • A hard prepay penalty would apply in the above circumstances, plus if you sold the home.

Penalties usually cover the first few years of a loan, because, as we mentioned, those are the riskiest for the lender. So if you refinance early on, you’ll trigger the prepayment penalty. The amount of the fee will differ based on the type of mortgage penalty fee you have. (See above models for an example of what that could be.)

As you’re reading through your Loan Estimateand 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 papers 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.

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What To Do With A Prepayment Clause

Does the thought of one more fee give you pause? It should – after all, no one wants to pay for something extra, especially when they think they are doing something that’s smart for their financial situation. Here are some things to consider before signing:

Run All The Numbers

Even if you don’t think you’re going to ever trigger the 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, if the costs are egregious.

Here’s what you should do: Find out the type of prepayment penalty that comes with your mortgage and compare the cost of living 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.

Should I Sign?

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 likelihood, i.e. how worried you should be about 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.
    • And if you already have a rock-bottom interest rate, you’re unlikely to be refinancing.
  • How important is it to you to have the ability to pay early?
    • If having long-term debt is too anxiety-inducing, you might want to consider mortgage lenders who don’t charge a prepayment penalty, just in case you come into a windfall and want to pay it all off. (Just remember you also will miss out on the mortgage interest deduction if you do so, so again, it’s important to weigh all financial factors.)

Prepare To Negotiate

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 (which, is, to be honest, unlikely but always worth a try), 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.

Skip The Fees: How To Avoid A Prepayment Penalty

In fact, that might be your best bet for reducing your anxiety and math angst: Remember that there are other alternatives to accepting a prepayment penalty. Yes, you can try negotiating it down, but the best way to avoid the fee altogether is to switch to a different loan or a different lender.

Since not all lenders charge the same prepayment penalty, make sure to get quotes from different lenders to find the best loan for you.

Alternatively, look for those lenders who don’t ever charge prepayment penalties, such as Rocket Mortgage®.

Sound like something you want to know more about? Get started now with your home purchase or refinance and enjoy the peace of mind that comes with knowing you’ll never have to worry about triggering a prepayment penalty, no matter how your financial situation changes.

Take the first step toward the right mortgage.

Apply online for expert recommendations with real interest rates and payments.

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